If you have equity in your home that you could really use, you may wonder if you should take out a cash-out refinance or a home equity loan/line of credit.
No two borrowers will have the same answer. What’s right for you depends on the situation. We’ll help you understand what factors you should look at when deciding.
What are the Interest Rates?
This is a big one. First, know your current loan’s interest rate. Next, find out what interest rate you can get today. Is it higher or lower than your current rate? If it’s higher, don’t touch your first mortgage. Instead, opt for the home equity loan or line of credit. If rates are lower though, go ahead and refinance. You’ll save money on interest and take out the larger loan that you need.
What’s Your Credit Score?
Lenders look loosely at your credit score and credit history when qualifying you for a mortgage. Home equity lenders may look a tad closer only because they are in second lien position. If you have a low credit score, you pose a higher risk of default. Lenders in second lien position get paid last, which could leave them without repayment if you default.
Will you Need to Use the Funds More Often?
A cash-out refinance and home equity loan pay you the funds in one lump sum. You get the money one time and that’s it. You make regular payments to pay it back.
A home equity line of credit works more like a credit card. You are issued a line of credit. You can withdraw some or all of the funds. You can even take nothing until you need it. Unless you withdraw funds, you won’t owe any payments. But if you do withdraw funds, you can pay interest or principal and interest. Just like with a credit card, if you pay the principal portion back, you can reuse it for the firsts 10 years.
What can you Afford?
There’s one major difference between the home equity loan and cash-out refinance (besides lien position) and that’s the required payment. If you take out a home equity line of credit, you only have to make interest payments on the money you withdraw. You don’t even have to make principal payments right off the bat.
If money is tight, this may be a better option. You don’t have to repay the principal until after 10 years. That’s when the draw period ends and you can’t use the funds of the line any longer. While making interest-only payments makes your payments higher once the repayment period starts, it may help you through tough times.
If the payment isn’t an issue, the cash-out refinance may be the better option. You’ll generally secure a lower interest rate, but you must make principal and interest payments right from the start.
Do you Want to Pay Closing Costs?
The closing costs are another major difference between the loan types. Closing costs on a first mortgage may cost as much as 5% of the loan amount, just like when you bought the home. The lender needs to obtain an appraisal, pull title work, and underwrite your loan.
Home equity loans and lines of credit, however, have minimal closing costs. The process isn’t nearly as entailed and many lenders offer home equity loans for very few closing costs, if any.
If you’re going to be in the home for the long-term, paying the closing costs may make sense, especially if you can get a lower interest rate. If you are in the home for the short-term, though, a home equity loan or line of credit may make more sense. You won’t fork out money for the closing costs and you won’t care as much about the interest rate since you won’t be there that much longer.
Which is Right?
So how do you decide? Answer all of the questions above and look at the big picture. Ask about the total closing costs, interest rates, and what the loan will cost you over its lifetime. Consider why you need the money ad where you stand on your first mortgage. If you have a great interest rate on your first mortgage, you may want to leave well enough alone. If you don’t, though, compare your options and see which helps you come out ahead now and at the end of the term.