In the aftermath of the Great Recession, pundits loved to gripe about “homeowners using their homes as ATMs.” Sure, just because you can take out debt doesn’t mean you should. But not all debt is bad debt; debt is a tool you can use wisely or foolishly.
And let’s be honest, sometimes homeowners find themselves cash-strapped but equity-rich.
If you’re considering pulling equity from your home, here are five ways you can do it, as well as the benefits and disadvantages of each. Just be careful not to overextend yourself financially. Equity can’t be realized until you sell; all you can do before then is borrow debt against it.
How to Pull Equity From Your Home
All home debt has a few things in common. First, most home debts report your payment history to the credit bureaus; exceptions include reverse mortgages and sometimes blanket rental property loans. If you miss a payment or default entirely, expect it to impact you credit score.
Similarly, if you default on debts secured against your home with a lien, the lender can foreclose on you. While you do have a few options at your disposal to stop a foreclosure, the risk of losing your home is real.
Finally, you can deduct the cost of interest on home-secured debts, but only if you itemize your deductions. If you don’t, it’s not particularly useful. Before diving into the five options to pull equity from your home, make sure you understand these similarities.
1. Cash-Out Refinance
If you have a home worth $300,000, and you only owe $150,000, you can refinance your mortgage and pull out more cash. Of course, it comes at the cost of higher home payments and restarting your loan amortization from scratch (more on that shortly).
Pros of Refinancing
Refinancing your mortgage comes with a few advantages. First, you can borrow money at a fixed interest rate, which means predictable mortgage payments. Your principal and interest payments never go up; only your property taxes or homeowners insurance premiums could cause your monthly payment to rise.
Another advantage is that lenders typically charge lower interest rates for refinances than other types of loans on this list. That’s because they hold first lien position with a refinance, which means their debt gets first priority in the event of a default and foreclosure.
Finally, refinancing lets you pull out a higher loan-to-value ratio (LTV) than the other options on this list for the same reason. A lender in first lien position can lend a higher percentage of the property’s value knowing that they get paid back first.
Pro tip: If you’re considering refinancing your home, look into Credible. It provides quotes from multiple lenders so that you can make sure you’re getting the lowest rates possible.
Cons of Refinancing
Refinancing your mortgage restarts your amortization from scratch, which lenders love. That should send up a red flag for you as the borrower.
Lenders use a calculation called “simple interest amortization” to determine how much of each monthly payment goes toward interest and how much goes toward paying down your principal balance. At the beginning of your loan term, nearly all of each payment goes toward interest, rather than principal. Over time, that ratio changes, until at the very end of your loan term, nearly all of each payment goes toward paying down your principal balance.
But here’s the thing: The change in that ratio follows an exponential curve, and it mostly happens at the very end of your loan. Over a 30-year mortgage, the bulk of your balance may only be paid in the last few years. So lenders love refinancing older loans because they get to restart the clock on amortization and collect high interest from each monthly payment.
Refinancing also restarts the countdown on your loan term. If you were 20 years into a 30-year mortgage, and you refinance for another 30-year mortgage, you go from having 10 years left on your loan to having another 30 years to go.
That fixed interest rate and payment also come with a downside: mortgages are inflexible. You borrow a fixed amount with a fixed repayment period, end of discussion.
If you’re thinking about refinancing to consolidate credit card debt, think hard. Defaulting on your credit cards means a judgment; defaulting on your mortgage means foreclosure.
Lastly, refinancing comes with a whole new set of closing costs. Between lender fees, title fees, appraisal fees, and more, prepare to spend thousands of dollars in fees.
The Bottom Line
Refinancing your mortgage to pull out cash can occasionally make sense – for example, if you have an FHA mortgage and want to refinance to a conventional mortgage to eliminate the mortgage insurance premium.
2. Second Mortgage/Home Equity Loan
If you already have a mortgage and want to borrow more money against your home, no one says you have to pay off your existing mortgage. One option is taking out a second mortgage, also known as a home equity loan. Similar to refinancing your original mortgage, you can use LendingTree to get the best rates on a home equity loan.
Technically speaking, the two terms don’t mean precisely the same thing. A home equity loan is any new mortgage loan that you take out as an existing homeowner. If you own your home free and clear, you can borrow a home equity loan, which would have first lien position rather than being a second mortgage. But in general discussion, the terms are often used interchangeably.
Pros of Home Equity Loans
One distinct advantage of a second mortgage is that you don’t have to restart the amortization schedule from scratch on your first mortgage. In the example above, the borrower has only 10 years left on their mortgage, so restarting the entire loan would come with a huge downside. But with a second mortgage, they can just take out what they need as a new additional loan.
Lender fees can end up being lower for a second mortgage than a refinance. Lenders often charge upfront fees called “points,” with 1 point equal to 1% of the loan amount. On a $30,000 second mortgage, 1 point is only $300, while 1 point on a $300,000 refinance is $3,000.
Second mortgages, being secured against your home, usually offer lower interest rates than unsecured personal loans. Of course, that lower interest rate may be nullified by the higher costs of running title work, recording lien documents, and the other requirements of a home mortgage closing.
Cons of Home Equity Loans
Second mortgages nearly always involve higher interest rates than refinances because the lender must take second lien position behind the first mortgage lender.
Home equity loans, like other types of mortgages, are also inflexible. That makes them useful only as a one-time infusion of cash – and an expensive one at that.
And as mentioned above, closing costs are expensive. No matter how small your loan amount, you still need to pay for title work, recording fees, appraisals, and fixed “junk fees” charged by the lender.
The Bottom Line
If you have a one-time cash need, such as paying for a home renovation, second mortgages can make sense. In particular, homeowners can use them as an option when they have a low-cost, advantageous first mortgage in place that they don’t want to lose.
But be careful of high closing costs, and look at the total cost of the loan, including all closing costs and life-of-loan interest compared with the amount of cash you want to borrow. No one wants to pay $60,000 in interest and fees to borrow $25,000.
3. Home Equity Line of Credit (HELOC)
As the name suggests, a HELOC is a revolving line of credit like a secured credit card. But instead of being secured by a cash deposit, it’s secured against your home. The maximum combined LTV for HELOCs typically falls in the 75% to 85% range. For example, for a home with a $150,000 mortgage that’s worth $300,000, instead of refinancing or taking out a second mortgage, you could take out a HELOC with a credit limit of $100,000.
For the initial draw period of five to 10 years, you can pull out money against the line of credit and pay down your balance as you like. The only payments you make each month are interest-only.
After the draw period comes the repayment period, when the line of credit closes and you must make monthly payments to pay off your balance. Repayment periods generally last 10 to 20 years.
Pros of HELOCs
The beauty of HELOCs is their flexibility. You may never need to use them, or you may use them only occasionally to pay for a home improvement before quickly repaying the balance. You could also max them out to cover an important cost.
Also, HELOC interest rates are typically lower than credit cards’ since they’re secured by your home. In general, rates fall in a similar range as second mortgages’.
Cons of HELOCs
Flexibility comes at a cost; HELOCs are adjustable-rate loans. Interest rates when you borrow may be low, but if they triple in the next 10 years, you could find yourself paying 16% interest on your debt.
Defaulting on your credit cards won’t necessarily mean homelessness, but defaulting on your HELOC might since the credit line is secured against your home.
As with second mortgages, homeowners may incur high closing costs to open a line of credit. The closing process is similar, requiring title work and all related fees.
Borrowers also face a unique risk with HELOCs: frozen credit due to loss of equity. If your home goes down in value, your lender can freeze your line of credit, regardless of whether you’ve made every interest payment on time.
Finally, some HELOCs include a permanent occupancy clause. Unlike mortgages, which typically allow borrowers to move out after a year and keep the property as a rental, some HELOCs automatically close if the borrower moves out, with the entire outstanding balance due immediately. Be sure to check the fine print.
The Bottom Line
Home equity lines of credit can make for flexible funding sources. From paying for home improvements to your kids’ college tuition to a down payment on a rental property or vacation home, HELOCs have many uses. They can even be used as a supplement or replacement for an emergency fund if you have a high risk tolerance and would rather invest your cash than let it languish in a savings account.
But as with second mortgages, be careful to analyze whether the long-term costs are worth the flexibility.
4. Reverse Mortgage
In a reverse mortgage, the lender pays the borrower rather than vice versa, with no obligation for the homeowner to make payments while they live. Upon their death, the house goes to the lender unless the borrower or their estate pays off the balance.
While reverse mortgages come in many shapes and sizes, the most common is that the lender makes monthly payments to the borrower, and the loan balance rises over time. Alternatively, the borrower could take a one-time payout, like a second mortgage, or some combination of a lump-sum payout and monthly payments.
Pros of Reverse Mortgages
Unlike the other options on this list, reverse mortgage lenders can’t foreclose. Depending on the terms of the loan, they may stop making payments after a certain number, but they can’t force the homeowner to leave. And because the borrower doesn’t make the payments, a bad credit score doesn’t matter.
As outlined above, reverse mortgages include some flexibility for borrowers to choose how they want to receive payments. Either way, the loan payments don’t impact the borrower’s eligibility for Social Security or Medicare benefits.
Cons of Reverse Mortgages
First, only older adults – usually those over 62 – can take out reverse mortgages. While this isn’t a con per se, it is a limitation.
Another limitation is that only a primary residence can be used as collateral for a reverse mortgage. Don’t count on taking one out on a rental property, no matter how much equity you have in it.
Now, for a serious con: mortgage insurance. For FHA reverse mortgage programs, borrowers must pay an upfront fee of 0.5% at the table if the loan balance is under 60% LTV and an ugly 2.5% for loan balances over 60% LTV. And that’s just the upfront fee. Borrowers must also pay ongoing monthly fees equal to 1.5% of the loan amount each year – an amount that often goes up over time.
The Bottom Line
For older adults with significant equity in their homes who never plan on moving out, reverse mortgages offer a viable source of additional revenue. They’re debt but without those pesky monthly bills.
But if you want to leave something behind for your children, be careful about how a reverse mortgage will impact your estate planning.
5. Buy a Rental Property With a Blanket Loan
Ready to get more creative in accessing your home’s equity?
Let’s say you want to buy a rental property. You find a lender who generously offers 80% LTV financing – or, in other words, requires a 20% down payment from you. You could cough up the cash, or you could offer to cross-collateralize your home.
It works like this: Instead of only securing a lien against the rental property, the lender puts a lien on your current home in addition to the rental. They get two properties as collateral, providing them with greater security. Because of the extra collateral, they no longer require a down payment at all.
Pros of a Blanket Loan
You don’t have to come up with any cash for a blanket loan. You can potentially finance even the closing costs of the new property. But you do gain a new income-producing asset.
This tactic also doesn’t require a separate settlement; you merely close on the property you’re buying with financing. The title company does have to pull two sets of title work, but any additional costs pale compared with the closing costs of a separate settlement.
Cons of a Blanket Loan
To begin with, you’re putting your home on the line to buy an investment property, risking foreclosure and homelessness, as outlined above.
Another risk of financing 100% of a rental purchase is negative cash flow. Such high mortgage payments may mean higher average expenses than rental income, which would defeat the entire purpose of buying a rental. Negative cash flow is a risk of buying a rental property when you buy at 70% to 80% LTV. The risk is even greater when you finance the entire purchase price.
Similarly, if the property dips even slightly in value, it puts you upside-down on the mortgage.
Buying a rental property with a blanket loan may seem similar to drawing on a HELOC. However, most investors I’ve known use this tactic only as a temporary source of funds so that they can buy at lightning speed. They quickly repay their HELOC after any repairs are complete, usually by taking out a long-term mortgage on the rental property. In other words, they don’t use their home to over-leverage a rental. Instead, they use it for temporary, fast, flexible money, which they repay in full with a separate rental-only mortgage.
The Bottom Line
Cross-collateralizing your home to finance investments is a high-risk venture. Don’t try this at home unless you’re an experienced investor with a dozen deals under your belt.
Debt is a dangerous tool, easy to abuse and difficult to wield skillfully. The best way to access the equity in your home is to sell the home and move somewhere less expensive. But if you must take out debt, borrowing against your home usually means lower interest rates than unsecured debts.
Just beware high upfront closing costs, and be especially careful not to take on more debt than you can repay. Most debt is, in fact, bad debt, and the only exception is debt that helps you build wealth. So if you can help it, listen to those grumpy pundits and don’t use your house as an ATM.
What has your experience been in accessing the equity in your home? Which of the above methods have you used, and what did you think of it?