Feb 4, 2019
Times are good! Real estate values have recovered from the last recession. And most folks now find they have quite a bit of equity in their homes.
Of course, that equity doesn't do much good just sitting there. Is it ever a good idea to use some of that equity to pay off credit cards, pay for college, or make home improvements? The answer depends largely on your current interest rate (on the existing mortgage and on any debt you'd like to eliminate), the new interest rate, the amount you need, and the length of time it might take to pay the money back.
There are two common methods to "cash out" on some of your equity: a cash out refinance or a home equity line of credit. There are advantages and disadvantages of each.
Cash Out Refinance
A cash out refinance involves refinancing your existing mortgage plus an additional amount (to pay off credit cards, make home improvements, or really anything you want), and closing costs. If you owe $250,000 currently, you need $50,000 to pay off credit card debt, and you'll have $5,000 in closing costs, you'd take out a new loan for $305,000.
The advantages? You only have to make one mortgage payment. Interest rates are still historically low. And you can choose a rate that is fixed for 30 years (or less).
The disadvantages? If you bought your home (or refinanced) in the last ten years, the interest rate on your new loan could be a little higher than the interest rate on your existing mortgage. Refinancing also comes with closing costs (although they can be rolled into the loan).
Home Equity Line of Credit (HELOC)
A home equity line of credit is a second mortgage. It involves leaving your existing financing in place and using some of the remaining equity in the form of a line of credit. HELOCs have draw periods during which you can pay the principal back and use it again, similar to a credit card. The draw period might be anywhere from five to ten years. During the draw period, most HELOCs allow interest only payments. After the draw period is over, principal and interest payments must be made until the loan is paid off (usually another ten to 20 years).
The advantages? If you have an uber low interest rate on your first mortgage, you don't have to give it up. Most HELOCs have few closing costs. And many lenders won't even require an appraisal. Automated valuations are usually used instead.
The disadvantages? Interest rates are usually higher than on a first lien, fixed rate mortgage. And that interest rate is almost guaranteed to increase. HELOCs usually have adjustable rates that are tied to the prime rate. When the Federal Reserve increases the federal funds rate, that typically increases the prime rate, which increases the interest rate on HELOCs. The prime rate increased 1.75% from December, 2016 to December, 2018. And further increases are all but guaranteed.
If you're tempted to make interest only payments during the draw period, you could also see a hefty payment increase when that draw period is over. Imagine you borrowed $100,000 at 4.25% (the prime rate plus 1%) five years ago. Today your interest rate would be 6.5%. Your interest only payments would have increased from $354 in February, 2014 to $542 in February, 2019. And if you had to start making principal and interest payments to pay off that $100,000 in the next ten years, you'd be looking at a whopping $1,135 per month!
So before you invest in a home equity line of credit, make sure you understand how the interest rate increases will affect your payment. And have a firm plan in place for paying off the balance as quickly as possible!
The Moral of the Story
There's often a lot of math involved in figuring out whether or not a cash out refinance or HELOC makes sense. If you're not a nerd like I am who loves sitting down with spreadsheets and amortization tables, contact a trusted mortgage lender. Let them help you figure out all the variables based on your unique situation.
And keep in mind that every financial decision doesn't have to be made solely by the numbers. Maybe a HELOC makes more sense financially but you wouldn't be able to sleep at night worrying about interest rate increases. Then by all means, get a fixed rate loan. Peace of mind is worth more than a few thousand dollars over 30 years!