Once you’ve established yourself as a homeowner, one of your largest lifetime expenses is under your belt. However, there may be other big expenses you still have to manage such as auto loans, student loans, medical bills and/or credit card debt. You may also encounter expensive milestones down the line like throwing a wedding or renovating your home. To pay for these big-ticket items, there are a few financing options to consider, regardless of whether you have a mortgage or own your home free and clear. In this month’s Insights, we explore how to take advantage of cash out refinances, home equity lines of credit and home equity loans.
The first order of business is to consider how much you still owe on your home versus its value. This will in turn determine the equity you hold in your home, which is essentially the current market value of the home minus the amount you owe on the mortgage. You can estimate the value of your home on sites like Zillow and Trulia as well as a quick conversation with a local real estate agent about the recent comparable home sales in your area.
Once you’ve determined an estimated value—and it’s recommended you go with a conservative, lower number—you can divide your outstanding mortgage balance over this value to calculate the loan-to-value (LTV) ratio. Most lenders won’t let you cross the 80 percent LTV threshold when considering additional financing options.
Now that you have an idea of the equity in your home, you should be prepared to discuss the amount of financing you need, its specific purpose and your current interest rate. These factors will help your lender, bank or credit union advise you on the best options for your financing needs.
If you’re looking for a revolving, flexible option, a home equity line of credit (HELOC) might be the right choice. A HELOC works like a credit card, except your home is used as collateral to borrow against, so the limit can be significantly higher than a credit card. Once you take out a HELOC, you have a limit on how much you can borrow at any given point, and you will only pay interest on the outstanding balance.
Typically, with a HELOC, you can access money during the first portion of the term e.g. 10 years and at a minimum, only pay monthly interest for what you’ve borrowed. Once the interest-only portion expires, you begin what’s called the repayment period, during which you pay down the principal, or balance of the line of credit along with interest. HELOC interest rates can be either fixed or adjustable during the interest-only period, then become adjustable thereafter. Obviously, anytime a rate is adjustable, it is subject to rise. Some homeowners open HELOCs simply to have during emergency situations, and keep their balance at zero. However, it’s not advised that you take out additional financing through a HELOC just because you can. It’s important to have a clear purpose in mind when borrowing more than your first mortgage.
Another option, especially for those with a set amount that they’d like to receive in a lump sum, is a cash-out refinance. A cash-out refinance entails refinancing your first mortgage at a higher balance, and receiving the difference between the new balance and your current balance in the form of a lump sum. This makes the most sense for those with a similar or higher interest rate than what is currently being offered, since your entire outstanding balance plus the cash out amount will be subject to a new rate. Since this is a refinance, you will also be restarting at a new term, i.e., 15 or 30 years.
If your interest rate is favorable on your first mortgage, you can consider a home equity loan or second mortgage for a fixed, lump sum amount without adjusting the term or interest rate on your first mortgage. Through these options, you are borrowing exactly what you need and repaying set monthly payments for a specific number of years. There are typically lower closing costs associated with a second mortgage or home equity loan, but the lump sum may have a higher interest rate. These solutions often make the most sense for a smaller lump sum that you plan on paying back quickly.
Each of these financing options has implications on what you can deduct annually on your taxes as well. It’s important to contact a tax professional to discuss what you can and cannot deduct in terms of mortgage interest, which may impact your decision.
Ultimately, the option you consider will depend on the amount you are seeking, what you are using the financing for, the equity you have in your home and what you can afford on a monthly basis in addition to your mortgage payments. By doing your homework upfront and outlining these necessary details, you will be prepared to discuss your options with your lender, bank or credit union.