Tapping the Equity in Your Home
At some point, most of us will feel a little strapped for cash. Maybe we didn't set aside enough money for our kids' college tuition. Perhaps the balance on those credit cards is larger than we'd like to admit. Or, it's finally time to update that harvest-gold kitchen.
Whatever the need, tapping into the equity built up in a home offers an inexpensive way to access funds. Most homeowners can do this in one of two ways: either by taking out a home equity loan, sometimes known as a second mortgage, or by setting up a line of credit. Both carry competitive interest rates right now, and in most cases homeowners can write off the interest on a loan up to $100,000 — no matter what the proceeds are spent on. And thanks to a slowing, but still strong real-estate market, most homeowners are sitting on more equity than they realize.
Financial Fundamental: Pay ahead on your mortgage
Home Equity Loans
A home equity loan is a second lien against a house. For the most part it operates like any other consumer loan. The homeowner then starts to repay the loan immediately, with scheduled monthly payments that include both interest and principal.
The majority of home equity loans are fixed-rate products often spanning 10 to 15 years. The interest rate, however, is typically higher for a second mortgage than for a first. That's because there's no secondary market and the lender has to keep the loans on its books, says Keith Gumbinger, of HSH Associates, a Pompton Plains, N.J., real-estate information firm. The going rate for a $30,000 home equity loan is about 8.1%, according to Bankrate.com.
A home equity loan is better suited for consumers looking for a one-time cash infusion, says Greg McBride, a senior financial analyst at loan-tracker Bankrate.com. It can be an especially good tool for those embarking upon a home-improvement project that will add value to the property, like updating a kitchen or adding an additional bathroom. It's also useful for consolidating high-interest debt such as credit cards.
Home Equity Line of Credit
A home equity line of credit, or HELOC, works a little differently than a loan. It's a variable-rate revolving credit line that feels more akin to a credit card with a maximum spending limit. Homeowners can borrow money, pay it back and then borrow more as needed. Accessing the funds is easy. All one has to do is write a check, charge a credit card or use an ATM card against the credit line.
Since interest is charged only on the money that's actually borrowed, a credit line works best for those with ongoing needs like recurring medical expenses or a long-term home-improvement project. Some financial planners also believe a line of credit is useful in case of an emergency, such as an unexpected job loss. In that event, just make sure not to use it for frivolous purchases like a new wardrobe.
But not all credit lines are designed the same, warns HSH Associates' Gumbinger. To avoid any surprises, make sure to ask what the terms are before signing on. Some will charge borrowers interest only, or just a nominal percent of the principal, during what's called an advance term that could last for, say, 10 years. Then, during what's referred to as a repayment period, the borrower can no longer access the funds and is put on a more traditional monthly payment schedule that includes both interest and principal. Don't be surprised to see a 5/10 or a 10/20 advance/repayment credit line advertised. (The first number shows how many years the credit line can be accessed; the second number shows how many years before the borrowed money, including interest, must be repaid in full.)
Another common line of credit includes a balloon payment. During the first 10 years, for example, a homeowner can borrower at will and only pay interest toward the loan. Then at the end of the agreement the entire balance is due. It's easy to imagine how this could get quite a few people into trouble if they don't budget properly. Fortunately, some lenders will allow borrowers to renegotiate the balance into a new loan with a fixed-rate monthly payment, says Gumbinger. But don't count on it. There are even some termless credit lines that don't expire until one moves.
Regardless of the type of Heloc selected, the interest rate should work out to be fairly low. That's because most credit lines fluctuate based on the prime rate, the rate banks use to set interest levels. The prime rate now sits at 7.75%. Since the borrower assumes a risk, lenders may charge a very small margin above the prime rate. But right now, a $30,000 Heloc carries an interest rate of just 7.88%, according to Bankrate.com. Add in the tax break, and it may feel like money really does grow on trees.
How Much Can You Borrow?
Borrowing levels depend largely on how much a house is worth. In a strong housing market, like the one experienced for much of the early 2000s, homeowners usually tap up to 75% to 80% of the newly appraised value of a residence (this is known as the loan-to-value ratio), minus the remaining balance on the first mortgage. So if a house was worth $400,000 and the owner owed $240,000 on the first mortgage, then that consumer could have borrowed up to $80,000, assuming, of course, that the payments could be met.
In today's market, a loan-to-value ratio of 75% to 90% of equity is common, according to Gumbinger. (Anything above 90% is hard to come by, he says.) But just because the bank will lend the money doesn't mean it's a good idea to take it all, warns Bankrate.com's McBride. The most common problem: A homeowner could end up owing money after selling a house. "Even if you can sell a home for its appraised value, you may realize the net proceeds are something very different," he says. There are, after all, many costs associated with unloading a dwelling, including lawyer and realtor fees. Also, you might lose part of your tax write-off. Any amount that you borrow over 100% of equity is not tax deductible.
The Application Process
Applying for a home equity product is similar to a first mortgage, only the process is far less rigorous. Most banks will appraise the property and run a credit check to make sure the borrower has the income to pay off the loan. If you have good credit, it takes a lot less time to get the money, usually just 10 to 15 business days. (If you have poor credit, you may never be approved, according to Gumbinger.) A first mortgage, on the other hand, can take 60 days or more.
Another benefit of home equity products vs. a traditional mortgage is the cost of entry. Most borrowers can get a Heloc with no closing costs; a second mortgage should only run a few hundred dollars.
But like any loan, borrowers should shop around for the best deal. As we mentioned earlier, there's really no secondary market for these products so offers can vary greatly. When it comes to a line of credit, watch out for inactivity and annual fees. As for second loans, some lenders will charge an upfront fee, typically a point, or 1% of the total loan. There's also been an upswing in early termination fees. Read the fine print. For some of the best deals, make sure to check out the smaller players in the market, such as credit unions and local banks. They can't compete on advertising so they often offer better rates, says HSH Associates' Gumbinger.
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