My wife and I purchased our home back in 2011 when rates were still relatively low after the Great Recession. Home values have risen significantly in our area since we purchased, so now we have about $175,000 in equity – our remaining mortgage balance is around $125,000 and the home value is over $300K now, according to Zillow. We have some repairs that we need to do and a few renovation projects we’d like to start, as well as some unsecured debt that it wouldn’t hurt to consolidate. Given that rates are so low again and our income is steady, is now a good time to cash in on that equity? If so, would it be better to do a cash-out refinance, or get a home equity loan or HELOC? Do we need to be worried that home values could fall again — and should we limit how much we borrow accordingly?
Mike in Florida
Denny Ceizyk, LendingTree Mortgage Expert, responds…
Hi Mike,
First of all, kudos for taking some time to do your homework on different ways to tap your equity. The three options you’re considering will allow you to convert your equity into cash that you can use for debt consolidation and home improvements.
Let me speak to your concerns about the direction of home values. At this point, home prices are on the rise, with many areas seeing double-digit, home-price appreciation from last year. That’s good news for any type of cash-out refinance program, because the more equity you have, the lower your rate will be. However, you’re completely right that you should limit how much you borrow to only what you need. If home values drop in the future, you’ll still have equity leftover in case you need to sell your home quickly.
Option 1: Cash-out Refinancing
A cash-out refinance makes sense if you can save on your interest rate and want the lowest possible payment for the life of the loan. Depending on how much you originally borrowed nine years ago and how much cash you need, your monthly payment might not increase that much given how low current interest rates are.
However, you might want to consider a 20-year, fixed-rate mortgage so you don’t restart the clock over with a 30-year term. The payment on a 20-year mortgage will be higher than a 30-year loan but if you can swing it, you’ll save a bundle in long-term interest charges. You can borrow up to 80% of your home’s value for a conventional or Federal Housing Administration (FHA) loan. A conventional cash-out refinance makes most sense if you have high credit scores and want to avoid private mortgage insurance.
If your credit scores range from 500 to 620, though, an FHA loan might be a better fit, although you’ll be stuck paying mortgage insurance premiums regardless of how much equity you have.
Option 2: Home Equity Loan
If you want to leave your current mortgage alone and plan to pay off all your debt and knock out the home improvements in one shot, a home equity loan may be a better option. You’ll receive the funds in a lump sum and typically have a fixed-rate payment.
Because you’re only borrowing the equity you need for your debt payoff and home improvements, your loan amount will be smaller. That translates to lower closing costs than taking out a larger mortgage amount with a cash-out refinance. You’ll pay about 2% to 5% toward closing costs, and you can usually borrow up to 85% of your home’s value with a home equity loan.
Option 3: HELOC
A home equity line of credit (HELOC) is a good option to explore if you have renovations you’ll complete in several phases, or just don’t need all the funds right away. HELOCs work like credit cards in that you get a revolving line of credit secured by your home. You can use the credit line as much (or as little) as needed and make payments only on the amount you use. The payments are often interest-only during the “draw period,” or about 10 years. After the draw period is over, the remaining balance is paid off in installment payments during the repayment period.
Most HELOCs are tied to a variable interest rate called the prime rate that may rise or fall based on financial market conditions. This means your payment may go up or down over time, which can be hard to budget for over the long haul. A credit score of 740 or higher is recommended for the best HELOC rates and, in most cases, you can borrow up to 80% of your home’s value. In addition to regular closing costs, HELOCs may require annual maintenance and close-out fees if you pay off the HELOC early.
Other considerations
Qualifying standards for home equity mortgage products are typically stricter. Credit scores, in particular, play a big role in the interest rate you’ll get for a cash-out refinance, home equity loan, or HELOC. A quick note about tax-deductibility: The interest on the extra cash you tap is deductible only if you use it for home improvements. Your tax professional can provide additional guidance.
Most lenders require an appraisal to verify your home’s value and pinpoint how much equity you can borrow. Appraisers take the condition of your home into consideration to determine its value. Removing clutter, making necessary repairs, and sprucing up your home, in general, is worth the effort. The appraiser will compare your home to recently sold homes that were staged or updated to sell quickly.
When you’re ready to apply, shop around for a lender. Not all lenders offer the same terms, so review loan estimates from three to five lenders to compare rates and terms. Finally, don’t forget that as with a first mortgage these loans are secured by your home. In other words, you could lose your home to foreclosure if you don’t repay them. Consider your other debts and financial goals before you move forward.
Good luck with your decision!
