The pros and cons of home equity loans, including a home equity line of credit or HELOC, home equity loan and cash-out refinance, are confusing to some borrowers.
Determining which type of equity loan is best for you depends on several factors:
- How much equity you have.
- How much you want to borrow.
- When you plan to repay the money.
- Whether you want a fixed or flexible term.
- The interest rate on your current mortgage.
Home equity line of credit
A HELOC is a credit line secured by your home. Most HELOCs have an adjustable rate, interest-only payments for a specified time, and a 10-year “draw” period, during which the borrower can access the funds.
After the draw period ends, the outstanding balance must be repaid. Typically, the repayment period is a 15-year term.
Homeowners with adequate income who don’t tip the debt overload scale can qualify for this type of loan. They can find this type of financing for 80 percent of combined loan to value or even 85 percent or 90 percent combined loan to value.
Combined loan to value, or CLTV
Lenders calculate the combined loan to value by adding all mortgage debt and dividing the total by the home’s current appraised value.
Formula: (Amount owed on primary mortgage + second mortgage) / appraised value
Example: Morgan owes $60,000 on the primary mortgage and has a HELOC for up to $15,000. The house is worth $100,000. The CLTV is 75%: ($60,000 + $15,000) / $100,000 = 0.75
The good and bad of a HELOC
Compared with a first mortgage, a HELOC can be a good way to borrow a small sum for a short time, says Justin Lopatin, vice president of residential lending at PERL Mortgage in Chicago. For example, you might borrow $20,000 that you plan to repay within three to five years.
One bad thing about a HELOC is it can be “very tempting” to access it, even if it’s not necessary, says Alan Moore, CEO of AdvicePay, a payment-processing platform for financial advisers.
“You have to carefully consider: What are your long-term goals? What is the money for?” Moore says. “Realistically, having easy access to money is not always a good thing.”
Home equity loans are less common
A home equity loan, like a first mortgage, allows you to borrow a specific sum for a set term at a fixed or variable rate. That’s why these loans are sometimes called second mortgages.
Home equity loans aren’t common, but some banks offer them.
Hybrid equity loans with fixed rates and terms
An alternative is a HELOC that’s structured like a fixed-rate home equity loan.
Kelly Kockos, senior vice president of home equity for Wells Fargo in San Francisco, says the bank offers a HELOC with a fully amortizing payment, which means the loan is repaid in full if all the payments are made through the draw period.
“With every payment you make, you pay down a little bit of principal and a little bit of interest. So, when you get to the end of your draw period, you don’t have a big payment shock,” Kockos says.
A fixed-rate advance option allows the borrower to lock in a portion of the credit line at a fixed rate and term. If interest rates change, the advance can be unlocked to float down to a lower rate, Kockos says.
Want only one mortgage? Go with a cash-out refi
A cash-out refinance is an entirely new first mortgage with cash back.
This option appeals to homeowners who want to refinance and take out cash at the same time.
“It’s a good way to grab equity and keep it all in one loan,” Moore says.
He cautions, however, that any loan or cash-out strategy must have a clear purpose. Don’t take the cash just because you can.
Lenders typically limit the cash-out refinance to 80 percent of the home’s value, says Jay Voorhees, broker and founder of JVM Lending, a mortgage company in Walnut Creek, California.
Check fees and interest rates
It’s important to compare closing costs and home equity loan rates. Fees might be higher for a cash-out refinance than they are for a HELOC, but the interest rate might be lower for a cash-out refinance.
The ability to lock in a low fixed rate is an advantage of a cash-out refinance, Voorhees says. “Whenever your payback period is going to be relatively slow, it behooves you to have a fixed rate because it’s much safer,” he says.
Your current interest rate matters
Your new monthly payment might be higher or lower than your current payment, depending on your interest rates, loan balances and repayment terms.
For example, if your existing mortgage has a very low rate and you go for a cash-out refi, you could end up paying a higher rate on your entire loan, not just the cash-out portion.
“If you bought (your home) in 2012 or 2013 and got a rate in the 3s, you may not want to touch that because it’s such a pristine loan that can’t be beat,” Lopatin says. “If you purchased (before then) and maybe haven’t refinanced, it may make sense to roll everything into one loan.”