Thinking about a home equity loan or line of credit? You might
be better off with a cash-out refinance of your current mortgage
Lenders are once again offering home equity loans and lines of
credit (HELOCs), after many suspended such offerings a few years
ago with the crash of the housing market. But they're still hard to
come by and have steep equity requirements, a far cry from the days
when lenders were actively encouraging borrowers to use their homes
as seemingly bottomless piggybacks.
Advantages of a cash-out refinance
Although many are leery of doing it these days, borrowing
against your home equity when you need cash can make good financial
sense. The interest rates are some of the lowest available and are
tax-deductable as well, since it's mortgage interest. The important
thing is to make sure you have sound reasons for needing the money,
rather than to fund lifestyle purchases of the type put many
homeowners deep into debt during the housing bubble.
A cash-out refinance offers several advantages over either a
home equity loan or a HELOC. To begin with, the interest rate is
usually lower. Interest rates on 30- and 15-year fixed-rate
mortgages are presently averaging about 3.9 and 3.2 percent,
respectively. Meanwhile, HELOCs are averaging around 4.6 percent
and home equity loans around 6 percent.
When you refinance, you're also reducing the interest rate on
your entire mortgage, so your savings are multiplied. At least,
that's true at today's historically low interest rates - if they
start rising again, you may no longer be able to significantly
reduce your rate through refinancing.
A cash-out refinance also allows you to get a stable rate.
HELOCs are typically adjustable-rate loans, meaning the rate can
change over time. Some HELOCs may start out with a very low rate,
but soon reset to a rate that can be much higher - which is
something you need to look out for in the fine print of the
The second lien issue
You also may find it easier to get a cash-out refinance rather
than a home equity loan or HELOC. Since home equity loans and lines
of credit are second mortgages, they're in a subordinate position
to your primary mortgage lien. In the event of a foreclosure, those
lenders don't get a dime until the primary mortgage is fully paid
off. When home values collapsed, many home equity loans and HELOCS
ended up with zero collateral behind them, because the remaining
home equity wasn't enough to even cover the primary mortgage. So
lenders are still a bit skittish about them.
Generally, the equity requirements for all three loan types are
the same - you need a loan-to-value ratio of no more than 80-85
percent before lenders will be willing to consider you for a
cash-out refinance, home equity loan or HELOC. Some will have even
more stringent requirements - to get the best rate on a HELOC, you
may need a loan-to-value ratio of 60 percent or better.
Advantgages of a HELOC or home equity loan
The big advantage of home equity loans and HELOCs is that their
closing costs are much lower than a cash-out refinance. So you need
to take that into account. A HELOC is also useful if you're not
sure exactly how much you're going to need or are only going to
need small amounts from time to time.
Since a HELOC is a line of credit, you only take out what you
need and pay interest on just what you borrow. So if you have a
$20,000 HELOC but only use $5,000 of it, the smaller number is what
you pay interest on.
With home values still steeply depressed from their pre-crash
highs, the number of homeowners with sufficient home equity to
borrow against is relatively small. Only 15 percent of all
mortgages refinanced last year were cash-out transactions,
according to the Mortgage Bankers Association. But some homeowners
continue to tap into their home equity, often for such purposes as
funding a business, home improvements, medical expenses or
educational costs. If you're going to be one of them, a cash-out
refinance could be the most cost-effective way to do it.