Which is the best option for borrowers seeking extra cash?
They say there’s no romance without finance. There’s also no kitchen remodel, new car, debt consolidation, college tuition payoff or outstanding medical bills settlement without it. Because the truth is that the biggest monetary transactions in our lives typically require outside funding in the form of a loan or line of credit. It’s a big reason why over 70 percent of homeowners owe debt on a mortgage loan, according to Zillow.
If you’re a homeowner who need a boost of extra cash to subsidize a major purchase or debt like the aforementioned, pursuing a high-interest personal loan from the bank or a buddy may not make much sense. Instead, you can turn to three viable options in common use today: a cash-out refi, a home equity loan, or a home equity line of credit (HELOC). Here’s a breakdown of each and the associated pros ()and cons ():
A cash-out refi is a refinance of any of your existing mortgage loans. It essentially allows you to obtain a new loan to pay off the current one and also take out equity (the difference between how much your property is worth and how much you owe on the mortgage) in the form of a one-time lump sum cash payment. This is a fixed-rate loan, typically for 30, 20, or 15 years, offering a relatively low interest rate (the current national average rate for a 30-year fixed mortgage is 4.26 percent, although the rate for a cash-out refi can be often be higher, especially if you want to roll the closing costs into the loan amount). This option also puts a new first position lien on your property in excess of the amount currently owed (“first position” refers to the order of the recording by your county clerk, dictating which mortgage must be paid first if you default).
- Allows you to lower your current mortgage interest rate and capitalize on a lower total rate than a home equity loan or HELOC
- You only have one loan and one payment
- The interest charged on this loan may be tax deductible
- Your first mortgage is reset, potentially adding extra years to the term until it is paid off
- You must borrow all the money at once and begin paying it off immediately every month
- The closing process can be lengthy, and closing costs can be as high as 7 percent of the total loan amount (although you can choose a no-closing-cost option that bundles closing costs into a higher interest rate)
Home Equity Loan
A home equity loan (HEL) is a type of mortgage loan in which the equity you’ve earned in your home is used as collateral. An HEL is referred to as a closed-end loan and a second mortgage; it puts a second position lien on your property, subordinate to the first lien. The loan term is usually shorter (5-15 years) than for a first mortgage. The term, monthly payment and interest rate is fixed (the current national average rate for HELs is approximately 6.1 percent), although adjustable-rate HELs are also available. The proceeds of the loan are paid out as a one-time lump sum, and you’re not allowed to borrow money on the loan in the future.
- Leaves your first mortgage alone
- Acquisition costs are typically lower than for a cash-out refi
- Interest charged on this loan may be tax deductible
- The interest rate is typically higher than for a cash-out refi and fees are often higher than for a HELOC
A HELOC is similar to a home equity loan in that it is also a second mortgage that is secured by using your property as collateral. However, a HELOC doesn’t pay out a lump sum; instead, it is more flexible because it functions as a revolving line of credit with an adjustable interest rate (commonly based on the prime rate, which is currently 3.25 percent, plus a margin; collectively, the current national average rate for HELOCs is 4.86 percent). Additionally, it lets you borrow only what you need when you need it: you can tap into a line of credit that can be available for up to several years. Interest doesn’t begin to accrue on this line of credit until you draw down on the line. HELOCs are often based on a 25- to 30-year term, with the borrower only paying down the interest monthly during the first 10 years, and the final 15 to 20 years fully amortizing (meaning there will be set monthly payments that include a interest plus principal to pay down the loan in full). Some HELOCs allow you to convert some or all of the loan balance into a fixed-rate loan prior to the end of the draw period, and you can opt later to: (a) bundle your HELOC’s outstanding balance into your existing first mortgage loan by refinancing; or (b) replace your HELOC with a fixed-rate second mortgage.
- The interest rate is often lower than for a home equity loan
- Easier and quicker to secure due to fewer lending restrictions
- You only draw the money when you need it and pay no interest on it until you do
- The interest rate is adjustable and can rise at any time, resulting in higher payments due
Which choice is right for you?
Many important factors should be carefully considered before committing to one of these financing options, says Casey Fleming, author of “The Loan Guide: How to Get the Best Possible Mortgage.”
“The right choice depends on a homeowner’s circumstances, the amount of financing needed, the state of your existing first mortgage, your income and cash flow, and your tolerance for risk,” Fleming says. “HELOCs tend to be the easiest and simplest to obtain because they’re not subject to Dodd-Frank rules or truth-in-lending regulations. Equity loans are the next simplest, but sources are more limited and they tend to be expensive. Cash-out refis are the most complicated to get, but are good if you don’t have a great mortgage already because they are the least costly option in the long run, in most cases.”
The best candidate for each vehicle is difficult to determine, agrees Yael Ishakis, vice-president of Pomona, N.Y.-headquartered First Meridian Mortgage; however, she provides food for thought based on the following hypothetical scenario:
Assume a homeowner named John wants to borrow $40,000 for a home improvement project. John has a preferred 740 credit score and a combined loan-to-value ratio of 80 percent (which means that the loan is limited to 80 percent of the appraised value of the property). Here are the true costs for each borrowing option:
|Interest Rate||Term||Monthly Payment||Total Cost To Borrow|
|4.5% fixed*||20 years||$253.06**||$63,202.26**|
Home equity loan
|6.1% fixed||20 years||$288.88||$71,801.32|
|4.75%***||20 years||$158.33 (years 1-10)***||$71,794.52***|
|$419.39 (years 11-20)***|
- *Rate based on no-closing-cost refinancing option (closing costs are bundled into the mortgage, accounting for the higher-than-normal interest rate; the current national average for a 20 year fixed rate mortgage, without closing costs included, is 4.125%)
- **Figures based on borrowing only the $40,000 cash-out portion; monthly payment and total cost of the loan will be higher when the total principal borrowed is included
- ***Adjustable rate based on the prime rate (currently 3.25%) plus a margin; the borrower only pays down the interest over the first 10 years; years 11-20 are fully amortized payments that pay down principal + interest + fees; monthly payment and total cost of the loan may be higher if/when the prime rate changes
Don’t overlook a home equity loan, however, says David Reischer, a New York City-based attorney and co-founder of LegalAdvice.com.
“A borrower who intends to take out a loan for a short period of time but plans to pay off the loan very rapidly may be more inclined to take out a home equity loan because they don’t incur closing costs (like a cash-out refi), despite the higher rate,” Reischer says.
On the other hand, you may be able to borrow more money with a cash-out refi, depending on your qualifications and the purpose of your refinance, says Victor Benoun, president of The Mortgage Source, Inc., Studio City, Calif.
“Home equity loans and HELOCs are often limited to $100,000; in some regions, up to $250,000. If you are borrowing less than $417,000, many lenders may lend up to that amount for the cash-out,” Benoun says.
Before beginning the process
To bag the right loan for your needs, be prepared to do your homework say the experts. That means sprucing up your credit-worthiness, shopping for the right lender, and knowing what to expect before and after you’ve been approved. Follow these steps to improve your chances of securing a loan:
- Determine approximately how much money you’d like to borrow. If you’re gearing up for a bathroom remodel, for example, aim for an accurate project cost estimate. Note that lenders today normally require a combined loan-to-value ratio of 80 to 90 percent (although it’s best to stay at or below 80 percent to avoid having to pay costly private mortgage insurance).
Improve your credit score by:
- paying your bills on time;
- paying down balances on any debt you currently owe;
- avoiding applying for new credit; and
- checking your credit report (which you can do for free at AnnualCreditReport.com) and correcting any inaccuracies there.
- Be aware that most lenders require a credit score of at least 680.
- Ensure that you have enough equity to make the deal work by determining the value of your home using an online valuation tool like Zillow or Trulia. Be ready to substantiate your income and assets] properly by gathering up important documents like tax returns, W2 and 1099 forms, and pay stubs from recent years.
“Also, make sure not to leave your job or take a leave of absence before or during the application process. That will make a loan denial happen,” suggests Ishakis, who cautions that it may be harder for self-employed applicants to obtain a loan.
As for where to apply, a cash-out refinance can be obtained from a bank, mortgage banker, credit union, mortgage broker or even your current lender, says Brian Krebs, owner of Duffy Home Loans in Alpharetta, Ga.
“Home equity loans and HELOCs, meanwhile, are typically are offered through banks and credit unions” (the latter require membership, but often provide lower rates and more favorable terms), Krebs says. “You can get referrals from accountants, financial planners or friends.”
Lastly, when shopping loans, make sure you carefully compare the interest rate and annual percentage rate, the monthly payment, fees, and, for cash-out refis, the closing costs (including points, origination fees, charges for title and appraisal, etc.). Request a good faith estimate and a clarification of any items you don’t understand within it.