Home equity lending, which nearly disappeared for a few years, is making a comeback. These days, if you've got sufficient equity in your home, there are legions of lenders who would be more than happy to cut you a check. The tricky part can be determining which type of loan is right for you.
Two popular types of mortgages that deliver cash are the second mortgage (aka home equity loan) and the cash-out refinance loan. There is no set rule on which one is better for a borrower. Therefore, base your decision on which loan best suits your personal needs. Here are a few things to keep in mind.
Deciphering home mortgage options
- How quickly do you need the money? Your typical cash-out refinance can take a month or longer to close. It's going to require an appraisal of the property, title searches and underwriting, with a close look at your credit and finances. While you and the property still need to be qualified for a second mortgage, those generally require less processing and can be closed more quickly, which makes them a more attractive option if you need the money ASAP.
If you don't need all the money at once, a home equity line of credit (HELOC) can be a good choice. A HELOC is a type of second mortgage that allows you to borrow money on demand, up to a preset limit. You get money as you need it, in the amounts you need, without having to reapply each time you borrow.
Furthermore, you only pay interest on what you've actually borrowed to date, rather than borrowing a lump sum up front and paying interest on the whole amount from Day One. This is a good option for situations where you need to make periodic expenditures over time, such as a home improvement project, starting a small business, funding college expenses, etc.
- What will it cost? One of the attractive things about a cash-out refinance is that they tend to offer very attractive interest rates. With a cash-out refinance, you're borrowing using a primary (first lien) mortgage, which has lower rates than a second (second lien) mortgage, because the primary mortgage gets paid off first in the event of a default.
However, the fees paid on a cash-out refinance tend to be much higher than on a second mortgage/home equity loan. That's because origination fees are typically based on the loan amount. With a cash-out refinance you're not only paying fees based on the additional cash you're borrowing, but on the amount to refinance your existing loan as well. On a second mortgage, your fees are assessed only on the cash you're receiving.
With a HELOC, you can often avoid closing costs entirely, although there is usually an annual fee for maintaining the line of credit.
- How much do you need? The amount you need to borrow can be a significant factor in determining which type of mortgage to choose. A cash-out refinance often makes more sense if you need to borrow a fairly large sum, particularly if it's a large amount relative to what you still owe on your mortgage. In that case, the lower interest rate on cash-out refi can save you a lot of money.
If you're looking to borrow a more modest amount, a second mortgage may be the better choice because of the lower closing fees involved, particularly if the amount you're looking to borrow is only a small fraction of what you still owe on your mortgage.
- How attached are you to your current home mortgage rate ? As mentioned above, people often choose a cash-out refinance because it tends to carry a lower rate. However, if your current first mortgage is already at a good rate, you may not want to refinance if rates are higher or little changed. In this case, choosing a second mortgage and committing to an aggressive repayment plan might make more sense over the long haul.
However, if refinancing would allow you to reduce your current mortgage rate by a full percentage point or more, you should give serious consideration to a cash-out refinance. You may find you can recoup your closing costs in just a few years, offsetting the immediate advantage of lower closing costs on a second mortgage.
- What is the right term for you? Most cash-out mortgage refinances carry a 15- or 30-year term. Second mortgages, however, are more flexible and can have much shorter terms. This can save you quite a bit of interest by paying the loan off more quickly, rather than rolling it into a long-term mortgage.
On the other hand, if you're looking to borrow a fairly large amount, a cash-out refinance may give you more manageable payment terms by allowing you to pay it off over a longer period of time, along with the rest of your mortgage.
- Are you in a cash crunch? If you are, consider that a HELOC typically allows you to make interest-only payments on your loan during the initial "draw" period when you can borrow against the line of credit (often 5-10 years). It's not a good maneuver over the long term, but it may help you shrink monthly payments so that you can get through a short-term cash crunch. Most HELOCs also allow you to pay down principal as you wish without penalty.
There are a variety of factors that play into your decision to choose between a cash-out refinancing and a second-mortgage. To help your decision-making process, prioritize your short and long-term goals. This will help you answer the questions listed above and ultimately choose the mortgage that makes dollars and sense for you.