Home Equity: How to Use It
What’s the difference between a second mortgage and a home-equity loan? What is a home-equity loan, and is it different from a home equity line of credit? And is a mortgage refinance similar to the above, or a different animal altogether? Let's take a look at all the various ways you can use your home equity – without fear of losing your home or getting taken for a ride.
First of all, a second mortgage and home equity loan are basically the same thing. These terms refer to money that is borrowed against the value of your house. Unfortunately, many people don’t realize that these loans are liens against your property – in other words, if you default on the loan, the lender then owns your home. You forfeit your house to pay what you owe, so it’s not like a credit card payment that you can skip when things get tight and just make up with extra interest later.
Now let’s look at the different ways you can use your equity that we have found to be helpful over the years.
Refinance: In essence, this is a way of paying off your current mortgage and getting cash out based on how much equity (the difference between the market value of your home and what you owe on it) you have in your home. If you haven’t done this yet, this is a great way to lower or lock in your mortgage interest rate. This is the way to get large sums of money – $30,000 or more – because you have 15 to 30 years to pay it off. Use caution, however: many lenders are offering to lend up to 125 percent of your home’s value, so if you default, you may still owe money even after your house has been repossessed! And the mortgage interest is tax deductible only on 100 percent of your home’s value, so you can’t claim any interest you pay on the overage.
On refinances, you may have to pay closing costs; discount points (used to increase the lender's yield or profit on the loan and equal to one percent of the loan amount); appraisal fees; application or loan processing fees; document prep and recording fees; origination or underwriting fees; lender or funding fees; loan broker fees; and miscellaneous other fees (i.e. overnight mail charges, etc.). You can negotiate on all these fees, and lenders sometimes offer “no-cost" loans, in which fees are rolled into the mortgage balance or absorbed by bumping up the rate. If you borrow 80 percent or more of your home’s value, your lender will require you to purchase private mortgage insurance (PMI).
A home equity loan, a.k.a. a second mortgage, is good for homeowners who don’t need quite as much cash and whose interest rate is already competitive. The interest rate is usually fixed and based on the prime rate, so it’s higher than regular mortgage rates. But the term is much less than a conventional 30-year mortgage – five to 15 years. And closing costs are much less than a refi. These installment loans are paid out in one lump sum, so they’re good for repaying credit card debt or any other high-interest, high-dollar fixed sum of money owed. They’re also one of your best bets for small to large remodeling projects, even buying a new vehicle.
Again, however, proceed with caution. You must be sure you will be able to pay this loan back, because you are putting your most valuable investment at risk – your home. It is easier to foreclose on a second mortgage (even though the amount is less than the home is actually worth!) than on a federally insured first mortgage. And you must commit yourself to shopping around and educating yourself. Find out about closing costs and points in advance, as well as balloon payments, hidden fees, or credit or property insurance tacked on.
Lastly, there’s the home equity line of credit. This works like a credit card – you agree to a pre-set limit and then borrow as you need to, or in the event of an emergency. A HELOC lets you tap into your home's equity as needed, usually for up to 10 years. These lines of credit are good for expenses like debt consolidation, major home improvements, college tuition and expenses, and unexpected expenses. The beauty of this is that you don’t make payments unless you use the money, but you have the security of knowing money’s there if you need it.
Some lenders may offer a lower interest rate if you pay points up front. Rates are usually variable, based on the prime rate plus some margin, and many can offer no closing costs loans.
And now for the caveats: some credit lines have variable interest rates, with no cap on how high they go. Make sure you read the fine print and find out exactly how much it could increase, then do the math. Could you afford it? Would you even want to? And if you’re an impulse buyer, this may not be a wise choice. A home equity line of credit shouldn’t be used for frivolous luxury items, unless it’s a one-time purchase and not a pattern of behavior.
Bradley Potter, PLLC
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