Tapping your home’s equity can be an effective way to consolidate debt, fund a home renovation or start a business. As you pay down your mortgage and your home increases in value, you build equity that you can access through a home equity line of credit or home equity loan.
These loans are second mortgages and are secured by your property. That means your home is used as collateral if you fail to keep up with payments. When you borrow against your equity, you’ll need to repay the loan with interest.
Learn more how the two types of second mortgages work and how you can decide if you should open one.
[SEE: Best Home Equity Loans]
How Does a Home Equity Loan Work?
A home equity loan will give you access to a lump sum of your home’s equity. After you get the lump sum, you’ll pay back the principal amount you took out and interest over time in scheduled monthly payments. Terms are typically five to 20 years, says Bill Murphy, a local Massachusetts branch manager at Fairway Independent Mortgage Corp. and a mortgage advisor for over 25 years.
Home equity loans also typically have a fixed interest rate.
“The rate is based on your loan-to-value (ratio), how much equity you actually have, your loan amount, how much you borrow. It’s also graded on your credit score too,” Murphy says. “The higher your credit score, the lower the interest rate.”
How Does a Home Equity Line of Credit Work?
A HELOC works more like a credit card. It’ll typically have a variable interest rate, and it will have a draw period where you can access the funds you need, usually for five years or more. During the draw period, you’ll only pay interest on the money you have used. Some lenders will offer fixed rates.
Interest rates for HELOCs are typically higher than for home equity loans. Because of that, some consumers can find them hard to pay off. Monika DeJesus, regional sales manager and senior loan officer with East Coast Capital, says, “We always encourage (clients) to try to pay towards principal if they can” during the draw period.
After the draw period ends, you’ll no longer have access to your funds and you’ll enter the repayment period. You will need to pay back both the interest and principal on the credit you used.
One thing to keep in mind is lenders can require you to use a certain percentage of your line of credit.
“I know a lot of (lenders) require you to take 75% upfront. Some of them want you to take 50% upfront, meaning at closing, and some will allow you to take as little as a set number, like $20,000 or 20% or 25%,” DeJesus says. “The terms are really important to read because they will vary depending on the lender.”
When Is Tapping Home Equity a Good Idea?
Tapping home equity can help you make investments where you expect to see a return or pay for one-off, big-ticket expenditures. Things like:
— Investing in education
— Renovating your current home
— Starting a small business
— Funding a big event
— Going on a once-in-a-lifetime trip
It’s important to avoid using your home equity to pay for regular expenses. This signals you are spending beyond your means.
“Ideally, (a home equity loan) should be part of a plan to get yourself into a better position in the future … and not have it be viewed as kind of like a form of paying for a lifestyle. We’d suggest a more conservative approach, but it could help people a lot feeling the pressure of the current inflation environment,” says Werner Loots, executive vice president of consumer lending at U.S. Bank. “It’s kind of like a one-time reset of your overall picture.”
If you’re thinking about getting a HELOC or a home equity loan, you’ll want to consider the interest rate you have on your current mortgage, the amount of equity you have in your home and what current interest rates look like. If you’re happy with your current interest rate and have a lot of equity to draw from, tapping into your equity may work in your favor.
“It obviously is a big decision … Using your home as collateral for a loan is a big choice,” Loots says. “These are big numbers. That’s part of the power of the home equity product.”
Speaking with a lending professional about your financial situation can also help you narrow down your choices and decide what’s best for you. Ultimately, you don’t want to end up relying on home equity long-term.
“I wouldn’t necessarily use it as a bank account for day-to-day purchases, unless you’re really, really disciplined. Most people have a hard time paying that back regularly,” DeJesus says. “You just don’t want to have that vicious cycle where it’s like, ‘wait now I’m in trouble again.'”
Can You Refinance a Second Mortgage?
You can refinance a second mortgage just like you would a first mortgage. Because your home equity loan or HELOC holds second position, after your primary mortgage, you’ll need to make sure your bank is willing.
“Most of the time, you can refinance with the same lender, which is usually your best bet. But of course, wait until the rates come down,” DeJesus says. “If you refinance with the same lender, a lot of times, if you’re getting a home equity line of credit, they’ll waive the closing costs if you don’t refinance under a year.”
Another option for refinancing is to combine your first and second mortgages together with a new, optimally lower, interest rate.
If you still have time in your HELOC’s draw period and want to keep your equity line open, you can also refinance your first mortgage and subordinate your second mortgage. The subordination process happens when you keep your second mortgage in place while allowing a new, refinanced first mortgage to go back into first position. There might be some subordination fees in the process.
“A lot of times, what I tell people is, call your creditor that sold you the second lien and ask them if they still allow the new first lien, or if they can close it and just put a new one in place without extra fees. Sometimes, the banks and credit unions and lenders will work (with you),” Murphy says.
[Read: Best Mortgage Refinance Lenders.]
Alternatives to Second Mortgages
Cash-Out Refinance
is a popular alternative to a home equity loan. It will restart your first mortgage without requiring you to take out a second one. You’ll get cash from your equity and will owe money on a new mortgage with a new interest rate.
Freeing up home equity can allow you to pay off debt that has tied up your cash flow.
If interest rates are low, a cash-out refinance may make more sense, allowing you to avoid adding on a second mortgage with a lot of new interest costs. But if rates are high, like they are now, tapping your home equity might be a better deal.
“If your first mortgage at the moment is 3%, like a lot of people in the country (who) are lucky for that to be the case, you can’t get a mortgage right now refinanced at that lower rate. So you’d prefer to leave that in place because that’s the most efficient choice,” Loots says.
Personal Loan
Unsecured debt, like a personal loan, is also an option if you’re able to handle higher monthly payments.
“For many people, the convenience of that, the speed at which those loans can be approved and disbursed, is attractive, even though the rate and the terms aren’t typically as compelling as home equity. It could fit your needs just fine if you don’t need that much money and if the repayment period is not something that you’re really trying to stretch out as much as possible,” Loots says.
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What Are the Requirements to Get a HELOC or Home Equity Loan?
When Is a Home Equity Loan a Good Idea? originally appeared on usnews.com
