You can tap into the equity in your home in two ways. A cash-out refinance or a second mortgage both have the same end result. You get cash in your hand. How do you know which one is right for you? Which one provides the better option? Here we will look at both options and weigh their pros and cons.
Looking at the Cash-Out Refinance
First, let’s look at the cash-out refinance. First, know this is a first mortgage program. You pay off your original 1st mortgage with the new mortgage. The difference this time around is the loan amount. You borrow more money than you need to pay off your mortgage. What you do with the extra money is up to you. Some people use it to pay off their debts. Others use the funds to fix up their homes. Yet others use it as an emergency fund.
The cash-out refi leaves you with a loan similar to your original loan. You have one monthly payment. The term and interest rate may differ from your original 1st mortgage. You don’t have to use the same lender for this loan; you are free to shop around.
Pros of the Cash-Out Refi
Let’s look at the benefits of a cash-out refinance:
- You can deduct most, if not all of the interest you pay on the mortgage since it’s your 1st mortgage
- A 1st mortgage usually provides a lower interest rate than a 2nd mortgage
- You can use it to consolidate debt, which may help increase your credit score
Cons of the Cash-Out Refi
There are also some disadvantages of the cash-out refi. Make yourself aware of them before taking this route:
- You’ll like get a higher interest rate than your current 1st mortgage
- You’ll pay closing costs similar to or even higher than your current 1st mortgage
- You put your home at higher risk since you borrow more
Pay careful attention if you decide to consolidate debt with your cash-out refinance. While it can be a great way to save money, it puts your home at risk. Let’s say you rolled your credit card debt into your 1st mortgage as a part of the cash-out process. You know put your home at risk for this debt. Before you rolled it in, though, it was likely an unsecured debt. If you didn’t pay it, the creditor couldn’t take your home. Now they can, though. Just make yourself aware of this possibility before taking out a cash-out refi.
Looking at the Second Mortgage
If you don’t want to touch your current 1st mortgage, you may need a second mortgage. You can take out a home equity loan or home equity line of credit. They have some similarities as well as some differences.
The home equity loan is a second mortgage. It provides you with a lump sum of money at once. If you take the cash out and don’t designate something to do with it, such as pay off credit cards, you receive it at the closing. You don’t have access to the funds again, though. In this instance, you pay principal and interest on the full amount withdrawn until you pay it off.
The home equity line of credit is a little different. It’s still a mortgage, but it works more like a credit card. You get a specific credit line. You can use as little or as much as you need up to the credit limit. Once you use it all, the funds are gone. However, you can pay the principal back. During the first 10 years, you have the option to pay interest only or principal and interest. If you pay principal, you can then reuse the funds during the draw period. Once the draw period ends, though, you can’t draw the funds any longer. You then owe principal and interest until the loan is paid off.
Pros of the Second Mortgage
There are several benefits of opting for the second mortgage rather than a cash-out refinance. They are:
- Your interest may be tax deductible. You should talk to your tax advisor about your situation to see if this is the case for you.
- Home equity loans and HELOCs usually have lower interest rates than credit cards or personal loans. This is because your home is the collateral.
- You can usually qualify for a much higher loan than any credit card company would provide.
Cons of the Second Mortgage
There are certainly a few disadvantages of using the second mortgage, whether a loan or line of credit. They are as follows:
- Your payment may adjust, especially with a line of credit. The interest rate usually varies based on a specific index. You may have a different payment from month-to-month.
- Any mortgage costs money to close. You will probably pay much more than you would for a credit card or personal loan.
- You have more than one mortgage payment to manage each month.
- Your home is at risk. If you don’t make your payments, you could end up with a home in foreclosure.
Which option is right for you? It depends on your circumstances. Look at your first mortgage. Does it have a low interest rate? Could you secure a lower rate today? How long have you paid on it? The answers to these questions will help you decide. For example:
- If you could secure a lower interest rate today and take cash out, it makes sense to take the cash-out refinance. If your rate is already low, though, you may not want to touch it.
- If you already made several years of payments on your first mortgage, you may not want to start the term over. If you can’t afford a 20 or 25-year term, you may want to leave your first mortgage alone.
Also, look at your qualifying factors. HELOCs often have the simplest requirements. The Dodd-Frank Act doesn’t affect them. Lenders can be a little more lenient about what they allow with HELOCs. A first mortgage, however, is much stricter. If you don’t have great credit and a low debt ratio, you may not qualify for the cash-out refinance.
Talking to several lenders can help you see your options. Each lender may have different programs, especially for a second mortgage. They often fund these loans themselves and/or sell them on the secondary market. With a little more leeway in the restrictions, you may find the 2nd mortgage to be a better option.
No two borrowers will be identical, though. Look at all of your options to decide which one will suit you the best.