Before unlocking your home equity, be sure to understand the costs and tax impact
If you own a house and are feeling a bit cash-strapped, there’s always the temptation to tap your home equity. Rising home prices have created record levels of equity for U.S. homeowners, reaching an estimated $15 trillion in , according to Federal Reserve data.
You’ve got three main strategies for unlocking your equity-a cash-out refinancing, home equity line of credit, or home equity loan. Of these options, cash-out refis are especially popular right now. More than 80 percent of borrowers who refinanced in the third quarter of 2018 chose the cash-out option, withdrawing $14.6 billion in equity from their homes, a report from Freddie Mac shows.
Before you make a move, though, be aware of the risks. You will be increasing your debt load while reducing your home equity.
“This money should be used for purposes that really add value,” says Michael Fratantoni, chief economist for the Mortgage Bankers Association. That means spending the cash on a home repair or paying off high-cost debt, rather than taking a vacation.
You will also want to consider the new tax rules, which have generally eliminated the interest deduction you were able to take for funds taken out through a cash-out refi, home equity loan or line of credit. Now, you can get a deduction only if that money is used for home repairs or improvements, says Lisa Greene-Lewis, tax expert at TurboTax.
To take that write-off, you must itemize, which is harder to do under the tax rules, which have nearly doubled the standard deduction. (For more details, see our story here.)
If pulling cash out of your home makes sense, your next step is to weigh the three options. (Keep in mind, if you’re in a hurry for the money, getting set up with a lender may take a couple of weeks.) Here’s what you need to know about these borrowing strategies.
In a cash-out refi, you refinance your primary mortgage for more than what you currently owe, then pocket the difference in cash. (That’s different from a standard mortgage refinance, which involves obtaining a lower interest rate while keeping your mortgage balance the same as it was before.) This form of borrowing generally provides the best option for pulling out a large amount of cash.
Say your house is worth $300,000, and you currently owe $200,000 on your mortgage. That gives you $100,000 in home equity, which means you can borrow $80,000-mortgage lenders generally let you borrow up to 80 percent of your home equity. In this example, let’s say you want to pull out $50,000.
To get that money, you would take out a new mortgage for $250,000 and receive a $50,000 check at closing. You will also pay closing costs, however, which range from about 3 percent to 6 percent of the loan amount-that’s $7,500 to $15,000 for a $250,000 loan. (Closing costs can be paid upfront, or they can be rolled into your new mortgage.) Rates for cash-out refis, which can be fixed or variable, were recently just under 5 percent, says Todd Sheinin, chief operating officer at Homespire Mortgage in Gaithersburg, Md.
To qualify for a cash-out refi, lenders look at your debt-to-income (DTI) ratio-how much you owe each month in obligations like credit card payments or mortgage loans divided by your monthly income. Generally that ratio cannot exceed 36 percent of your gross monthly income, says John Muth, certified financial planner at Northwestern Mutual.
Home Equity Line of Credit
With a home equity line of credit, or HELOC, you have a source of funds that acts a lot like a credit card. You can take multiple loans over the term of the loan, typically 10 to 20 years, which is often referred to as the “draw period.” Many mortgage lenders will even issue you a HELOC card, much like a credit card, which gives you easy access to the money.
“If you are taking out a relatively small amount, maybe $10,000 to $20,000, it might make more sense for the HELOC, especially if you have a really great rate on your first mortgage now,” Sheinin says. That’s because you would probably have to refinance at a higher rate if you do a cash-out refi instead.
You can typically borrow 75 percent to 80 percent of your home’s appraised value, minus what you owe. (Some lenders allow you to borrow up to 90 percent.) After the draw period-typically 10 to 20 years-any outstanding balance (principal plus interest) must be paid back. The interest rate for a HELOC is typically variable and higher than that of a cash-out refi-recently 6.27 percent, according to .
Generally there are no closing costs for a HELOC, although you may be charged an appraisal fee (usually $300 to $400) and an annual fee of about $100 or less. Underwriting and eligibility requirements are less stringent for HELOC borrowers than they are for cash-out refis, Sheinin says. Even if you don’t need cash right away, it may make sense to set up a HELOC as a stand-by emergency fund.
Home Equity Loan
The home equity loan, or second mortgage, is the most straightforward of the strategies. You borrow against the value of your house, and receive a lump sum of money upfront, which you begin repaying with interest immediately. The recent home equity loan rate, which is fixed, averaged 5.92 percent.
You can borrow 80 to 85 percent of your home’s appraised value, minus what you owe. Closing costs for a home equity loan typically run 2 to 5 percent of the loan amount-that’s $5,000 to $12,000 on a $250,000 loan.
If you are seeking a fixed interest rate, and you know exactly how much money you need, a home equity loan can be a great option, says Sheinin.