Thinking about a home equity loan or line of credit? You might be better off with a cash-out refinance of your current mortgage instead.
Lenders are once again offering home equity loans and lines of credit (HELOCs), after many suspended such offerings a few years ago with the crash of the housing market. But they're still hard to come by and have steep equity requirements, a far cry from the days when lenders were actively encouraging borrowers to use their homes as seemingly bottomless piggybacks.
Advantages of a cash-out refinance
Although many are leery of doing it these days, borrowing against your home equity when you need cash can make good financial sense. The interest rates are some of the lowest available and are tax-deductable as well, since it's mortgage interest. The important thing is to make sure you have sound reasons for needing the money, rather than to fund lifestyle purchases of the type put many homeowners deep into debt during the housing bubble.
A cash-out refinance offers several advantages over either a home equity loan or a HELOC. To begin with, the interest rate is usually lower. Interest rates on 30- and 15-year fixed-rate mortgages are presently averaging about 3.9 and 3.2 percent, respectively. Meanwhile, HELOCs are averaging around 4.6 percent and home equity loans around 6 percent.
When you refinance, you're also reducing the interest rate on your entire mortgage, so your savings are multiplied. At least, that's true at today's historically low interest rates - if they start rising again, you may no longer be able to significantly reduce your rate through refinancing.
A cash-out refinance also allows you to get a stable rate. HELOCs are typically adjustable-rate loans, meaning the rate can change over time. Some HELOCs may start out with a very low rate, but soon reset to a rate that can be much higher - which is something you need to look out for in the fine print of the loan.
The second lien issue
You also may find it easier to get a cash-out refinance rather than a home equity loan or HELOC. Since home equity loans and lines of credit are second mortgages, they're in a subordinate position to your primary mortgage lien. In the event of a foreclosure, those lenders don't get a dime until the primary mortgage is fully paid off. When home values collapsed, many home equity loans and HELOCS ended up with zero collateral behind them, because the remaining home equity wasn't enough to even cover the primary mortgage. So lenders are still a bit skittish about them.
Generally, the equity requirements for all three loan types are the same - you need a loan-to-value ratio of no more than 80-85 percent before lenders will be willing to consider you for a cash-out refinance, home equity loan or HELOC. Some will have even more stringent requirements - to get the best rate on a HELOC, you may need a loan-to-value ratio of 60 percent or better.
Advantgages of a HELOC or home equity loan
The big advantage of home equity loans and HELOCs is that their closing costs are much lower than a cash-out refinance. So you need to take that into account. A HELOC is also useful if you're not sure exactly how much you're going to need or are only going to need small amounts from time to time.
Since a HELOC is a line of credit, you only take out what you need and pay interest on just what you borrow. So if you have a $20,000 HELOC but only use $5,000 of it, the smaller number is what you pay interest on.
With home values still steeply depressed from their pre-crash highs, the number of homeowners with sufficient home equity to borrow against is relatively small. Only 15 percent of all mortgages refinanced last year were cash-out transactions, according to the Mortgage Bankers Association. But some homeowners continue to tap into their home equity, often for such purposes as funding a business, home improvements, medical expenses or educational costs. If you're going to be one of them, a cash-out refinance could be the most cost-effective way to do it.