Feeling house-rich and cash-poor?
Many homeowners find equity both gratifying and maddening. They own a valuable asset with tens or even hundreds of thousands of dollars of untapped equity, but accessing that equity is neither easy nor cheap.
The first rule of home equity is to remember that it exists only on paper. It doesn’t become real in any functional sense until you sell your home, which you may not plan to do for years.
The closest you can come to realizing it before you sell is borrowing against it. You have several options to pull equity from your home, the two most common being home equity loans (second mortgages) and home equity lines of credit (HELOCs).
Like any other debt, each of these come with their own risks and advantages. Here’s what you need to know about home equity loans and HELOCs before signing on the dotted line for additional debt.
Home Equity Loans
A home equity loan is a new mortgage against a home you already own, used to tap into existing equity. In other words, it’s a non-purchase mortgage. LendingTree is a great place to start when looking for a home equity loan.
Usually, that means a second mortgage – although, technically speaking, if you own your home free and clear, you could take out a home equity loan as a first mortgage. A refinance mortgage, even a cash-out refinance, does not fall under the definition of a home equity loan.
Technical differences aside, however, the terms “second mortgage” and “home equity loan” are often used synonymously.
Advantages of Home Equity Loans
The best way to understand the pros and cons of home equity loans is to compare them to other types of debt.
Say you own a home with $100,000 in equity, and you want to access that equity. Your mortgage lender keeps sending you mailers urging you to refinance to pull cash out, and you’re tempted.
But you’re often better off taking out a second mortgage rather than refinancing your first mortgage. First, any points charged by the lender on a second mortgage will be on a smaller loan amount. A “point” is a lender fee charged at settlement equivalent to 1% of the total loan amount. Thus, a point on a $50,000 second mortgage is only $500, whereas a point on a full $350,000 refinanced mortgage is $3,500. You can see how size matters when it comes to home loans.
Fees aside, there’s a more subtle reason why lenders prefer to refinance your first mortgage – and why you should be wary. It’s called amortization, and the short explanation goes like this: At the beginning of your loan term, nearly all of your monthly mortgage payment goes toward lender interest, and almost none goes to paying down your principal balance. As time goes by, that begins to shift, and gradually, more of your monthly payment goes to paying down your balance rather than interest. By the last few years of your mortgage, most of your monthly payment goes toward principal.
So the further along you are in your loan term, the less profit the lender makes. They want to restart the amortization schedule so that they can claim more of your payments as interest – which is why you should guard against refinancing unless your current interest rate is dramatically higher than your offered refinance rate. And given how long interest rates have been low, few Americans are currently strapped with high-interest mortgages.
Speaking of interest rates, you can lock in a fixed interest rate with a second mortgage, which is great. The same can’t be said for HELOCs (more on them shortly).
Disadvantages of Home Equity Loans
Because mortgage lenders make more money by refinancing, they try to incentivize you to refinance rather than take out a second mortgage. They’re also better protected against defaults when they have first lien position rather than second.
The first way they tempt you to refinance is by offering significantly lower interest rates, so be prepared to pay more in interest for a second mortgage rather than a first.
Lenders may also charge more in fees and points for a second mortgage. Follow these tips to secure a low-interest mortgage when shopping around and negotiating with lenders.
And even though the loan amount is relatively small for a home equity loan, you still have to pay all the same flat fees at settlement. These fees include title reports and other charges, settlement agent fees, lender “junk fees,” appraisal fees, and recording fees. Whether you borrow $30,000 or $300,000, these fees typically remain the same.
In fact, all those settlement charges often mean you’re better off taking out a personal loan or a cash advance on your credit card, even though the interest rate is likely higher. Compare the total costs of a home equity loan, include all closing costs and life-of-loan interest, to the alternatives before making a decision (more on alternatives later).
Finally, home equity loans are rigid compared with rotating lines of credit such as HELOCs. They’re classic loans with no flexibility; you get a one-time advance of cash, and then you make monthly payments for the next 15 to 30 years – the end.
Common Uses of Home Equity Loans
One of the most common uses of second mortgages is renovation projects. You dream of installing a pool, sunroom, or 15th-century Turkish bath, but you can’t afford to pay in cash. So you borrow the money against your home’s equity, figuring that the improvements will increase your home’s value.
That’s a dangerous assumption to make as not all renovations do improve home values, and most don’t pay for themselves in the form of equity. You may be better off doing home improvements that reduce your ownership costs; at least you’ll save money on a monthly basis.
Another common use of home equity loans is debt consolidation. A homeowner with 10 different loans, ranging from student loans to auto loans to credit card debt, may decide they’d rather have one big loan than 10 small ones. Again, that may or may not make financial sense; read up on the pros and cons of debt consolidation before proceeding.
The list of expenses that people use second mortgages to pay is endless: adult children’s college tuition, medical expenses, starting a business – you name it. If it’s expensive, homeowners have turned to a second mortgage to pay for it.
Home Equity Lines of Credit (HELOCs)
A HELOC is a rotating line of credit, much like a credit card, that’s secured against your home. In other words, the lender places a lien against your home, just like a mortgage lender does, so if you default, they foreclose. While credit cards charge cash advance fees and place lower limits on cash advances than retail purchases, HELOCs are designed specifically for cash withdrawals.
HELOCs typically have two phases: a draw phase and a repayment phase. In the initial draw phase, which lasts five to 10 years, you can either pull money out or pay it back. After the draw phase ends, your balance locks and you enter the repayment phase. At that point, the HELOC effectively becomes a second mortgage, and you make regular payments over the course of 10 to 20 years.
Pro tip: Figure.com offers a home equity line of credit with rates starting at 4.99%. You can get approved in five minutes and have funding in just five days.
Advantages of HELOCs
The most obvious benefit of HELOCs is their flexibility. You can borrow money as you need it, pay it back, and then borrow more.
And as with second mortgages, you get to access your equity without refinancing and restarting your amortization from scratch.
HELOC interest rates are often similar to second mortgages’. That makes them higher than first mortgages but lower than most credit cards or personal loans since the line of credit is secured with a lien against your home.
Disadvantages of HELOCs
Unlike second mortgages, HELOCs don’t offer fixed interest rates. Since they’re a rotating line of credit, you can expect the interest to be tied to the fluctuating prime rate. That means you can’t lock in a loan at the current low interest rates. Today’s affordable line of credit might morph into a crushing high-interest debt tomorrow.
Another difference from second mortgages is that HELOCs can freeze your credit if your home drops in value. You can only count on your HELOC to the extent that your equity doesn’t dip.
One risk few homeowners realize is the restriction on renting that most HELOC lenders impose. With a mortgage, you can move out of your home and keep it as a rental if you’ve lived there for at least a year. But many HELOC lenders call your credit line if you move out of the home.
For all these differences, HELOCs do share a few unflattering similarities with home equity loans. The first is closing costs; expect to pay comparably high fees and charges at the settlement table, from title fees to appraiser fees to lender fees.
Then, there’s the risk of prepayment penalties. While these are also a risk with second mortgages, they pose a greater problem with HELOCs. A prepayment penalty is a fee charged by the lender if you pay off the debt in full before a certain date – which can defeat the entire purpose of a flexible line of credit to draw on or pay off as you see fit. Not all HELOCs include a prepayment penalty, so double-check before borrowing.
Pay particular attention to “no closing cost” HELOCs. Home lenders aren’t exactly philanthropic charities, so if you see a “no closing cost” HELOC advertised, dig deeper to discover exactly where the hidden fees – such as prepayment penalties – lie.
Finally, bear in mind that once the HELOC rolls over to the repayment phase, it goes on an amortization schedule just like a traditional mortgage. As outlined above, that means most of your monthly payment goes toward interest for the majority of the loan.
Common Uses for HELOCs
Like home equity loans, homeowners use HELOCs to pay for big-ticket expenses such as home renovations, college tuition, debt consolidation, and medical bills.
But the added flexibility of HELOCs allows for some more creative uses as well. For example, as a real estate investor, I’ve seen fellow investors use HELOCs creatively to fund their down payments or renovation costs for new rental properties or flipping houses. Upon completing the renovations, they either sell the house (in the case of flipping) or refinance it with a long-term fixed mortgage (in the case of rentals) and pay back their HELOC in full.
Alternatively, some homeowners maintain HELOCs as an extra layer of protection against emergencies. Instead of keeping many months’ worth of expenses in a cash emergency fund, they keep a fraction of the money in cash, knowing that they can draw on their HELOC if an emergency strikes. That frees them up to invest more of their money, capitalizing on compounding and protecting against inflation.
Alternatives to Second Mortgages & HELOCs
Both second mortgages and HELOCs come with worryingly high closing costs. We’re talking four figures. And if you default, you lose your home.
For all their uses, home equity loans and HELOCs aren’t your only options. Consider these alternatives before signing a second debt against your home.
1. Personal Loans
It’s worth reiterating: Closing costs on home equity loans and HELOCs are expensive. Prepare to blow $3,000 to $10,000 or more.
In any context, your jaw would drop at losing that kind of money. Yet homeowners brush these costs off for two reasons: they get rolled into the loan, and they appear smaller relative to the high numbers of home values and mortgage loans.
Yes, personal loans usually come with higher interest rates than second mortgages. But they also come with dramatically lower fees because the lender doesn’t have to run a title history, order an appraisal, record a lien, or hold a formal settlement.
Compare the total closing costs and life-of-loan interest before committing to a second mortgage over a personal loan. You may be surprised to find personal loans are cheaper despite the nominally higher interest rate.
Pro tip: If you’re looking for a personal loan, start your search at Credible.com. You will receive rates from multiple lenders in just two minutes.
2. Credit Cards
Just as personal loans offer an unsecured alternative to home equity loans, credit cards offer an unsecured alternative to HELOCs.
The same logic applies: Even though the interest rates are higher for credit cards, they don’t come with massive closing costs. Many cards also don’t come with any initial or annual fees, for that matter.
And while you may like the idea of pulling cash from a HELOC, you can still borrow cash from a credit card. Typical cash advance fees fall in the 3% to 4% range, which is still far lower than what you’d pay in total HELOC closing costs.
Scope out these low-APR credit cards, which may only charge marginally higher interest than a HELOC with none of the steep settlement charges.
Yes, you need to consider amortization schedules and deceptive lenders twisting your arm to refinance. But refinancing is still an option as an alternative to home equity loans and HELOCs.
If you currently have a high-interest mortgage that isn’t too far along in its amortization, you may find it makes sense to refinance to a lower-interest loan. For example, if you bought your home when you had poor credit and have since boosted your credit score by 100 points, you may find far cheaper loan options available to you today.
4. Reverse Mortgages
For retired homeowners over the age of 62, reverse mortgages offer an additional source of income.
Reverse mortgages come in many colors; you can take a lump sum payout, collect monthly payments, or opt for a line of credit similar to a HELOC. Or, for that matter, you can choose a combination of those options.
Unlike traditional loans, you don’t make any payments on a reverse mortgage, ever. When you die or sell the property, the lender gets their money back.
Because you don’t make monthly payments, your credit score doesn’t matter. But just because you don’t make payments, that doesn’t mean the loan is free. Expect to pay all the traditional settlement charges, plus an annual mortgage premium of 1.5%.
Do your homework on reverse mortgages before borrowing one. They’re unusual and easy to misunderstand, but they can offer much-needed income for cash-strapped retirees.
5. Private Funds
No one says you have to borrow from a bank or corporate lender. You can borrow from friends and family and often pay considerably lower interest and fees.
In my experience, it doesn’t even occur to private “lenders” to charge fees because they aren’t following a lender’s business model. They instead think like investors, looking at risk and return. When you approach them to discuss loans, don’t offer upfront fees, but instead offer high interest rates to satisfy their desire for strong returns.
To reassure them that you’re a low-risk investment, offer collateral. You could let them hold a valuable piece of jewelry or the deed to your car or even your home – something that serves to put their mind at ease without you having to pay out-of-pocket for hefty closing costs.
As with the other types of unsecured credit outlined above, what you give up in higher interest, you recover in avoided settlement costs. And your sister probably won’t kick you out of your house if you don’t pay her back on time. Probably.
6. Boost Your Savings Rate & Avoid Debt Altogether
Yes, there is technically such a thing as good debt. By definition, good debt makes you richer in the long term; examples include student loan debt and investment property loans, both of which can raise your income. But very few homeowners take out a home equity loan or HELOC for “good debt” purposes.
Rather than weighing yourself down with home equity debt, do your future self a favor and increase your savings rate instead. Spending less and saving more may not be as sexy as getting the money right this second to install that swimming pool, but it’s how you come out ahead in the game of building wealth.
For an easy way to supercharge your savings rate, consider house hacking to eliminate your housing payment. Then you can take your savings each month and invest it in an investment account with M1 Finance or put it in a high yield savings builder account with CIT Bank.
There was a saying that pundits loved to throw around in the aftermath of the 2008 housing crisis. They criticized homeowners for “using their homes like an ATM.”
Yes, it was patronizing. But make no mistake, they were talking about people taking out home equity loans and HELOCs so they could spend their equity now instead of waiting until they realized those gains by selling their homes.
As you evaluate your options for borrowing money, always be careful to run the total life-of-loan costs. Compare not only the pros and cons of HELOCs and home equity loans but also the alternatives laid out above. And be especially careful not to grow complacent about spending $5,000 in closing costs simply because it looks small in the context of a $250,000 home value.
Have you taken out a HELOC or home equity loan? What was your experience with it?