If you have equity in your home, you probably wonder what the best way to tap into is given your situation. Most homeowners deal with this debate. There isn’t a set right or wrong answers – it depends on your qualifying factors and what you want to do with the money.
Keep reading to figure out what you should do.
Understanding the Home Equity Loan
A home equity loan is a second lien on your property. You don’t refinance your first mortgage when you take out a home equity loan. You apply for a separate loan in the form of a line of credit or an actual loan. Here’s the difference:
- Home equity line of credit – You get a line of credit, similar to a credit card. You can spend the credit line as you see fit. You can even reuse funds that you’ve repaid. You only pay interest on the amount that you withdraw. This goes on for the first 10 years. After that, the line closes and you enter the repayment period. During this time, you pay both principal and interest on your outstanding balance.
- Home equity loan – This is a typical loan. You receive the full amount of the loan in one lump sum. You do what you want with the funds. You cannot reuse the funds if you pay them back. You make principal and interest payments on the loan from the start. It typically has a 15-20 year term versus the 30-year term of the HELOC.
You can decide between the two options if you decide a home equity loan is right for you. Choosing between the two typically depends on your needs for the funds. For example, do you have a one-time need, such as to make a major repair on your home? A home equity loan might make sense, then.
If you need future access to funds or you don’t know the exact amount that you’ll need, a home equity line of credit may be better. Maybe you are putting an addition on your home. You probably won’t know the exact amount that you will need as different needs will arise as you go through the process. Just make sure that you are able to make the full interest and principal payment at the end of the 10-year draw with this option.
Understanding the Cash-Out Refinance
The cash-out refinance does refinance your first mortgage. Your new lender will pay off your existing mortgage and give you the proceeds that are left. You do what you want with the funds and you start making mortgage payments (principal and interest) right away.
Because this is a first lien on your property, lenders often put you through a more rigorous qualification process. While this might seem annoying or tedious, it could work in your favor. If a lender decides you are a good risk, you may be able to receive more money in hand, than you could for a home equity line of credit or loan. Second mortgage lenders take a larger risk because if you default on your loans, the first lienholder has priority on the loan. If there aren’t enough funds to satisfy the first lienholder and the second lienholder, the second mortgage company usually takes the loss.
First mortgage lenders can usually offer better interest rates and terms on their loans. But, like the home equity loan, you only get access to the funds once. If you use the funds up, you don’t have access to more funds unless you refinance again.
How to Decide
So how do you decide between your three options? Ask yourself the following questions:
- Do you have a good interest rate on your first mortgage? If you do, you may not want to refinance and risk taking a higher interest rate as cash-out refinances usually have slightly higher interest rates than borrowers get when purchasing a home.
- Do you have future needs for the funds? If you know you’ll have more than one-time need for the funds, the HELOC may be the better option. You’ll have access to your credit line for 10 years, which can help with future expenses, should you need it.
- Do you have good qualifying factors? If you don’t, you may want to opt for the home equity loan, which is easier to qualify for as it’s for a lesser amount of money. Second lienholders may be a little more relaxed with their guidelines than a lender offering a cash-out refinance may offer.
Answering these questions can give you a little insight as to what you need. You should then ask for quotes from several lenders for all three loans. This way you can compare your options and see which one makes the most financial sense for you.