More people are turning to cash-out refinances because of rising real estate values.
Before you unlock your home equity, however, be sure you understand the costs and tax implications.
If you own a house and are feeling a bit cash-strapped, there is always the temptation to tap your home equity. Money should be spent on things that add value.
However, paying back high-cost debt or making repairs to the house is the best option on borrowed money, not a vacation or more spending.
Taking advantage of your equity can be accomplished through three different strategies: a cash-out refinance, a home equity line of credit, or a home equity loan.
Of these options, cash-out refis are especially popular right now.
Home Equity Line of Credit
With a home equity line of credit or HELOC, you have a source of funds that acts a lot like a credit card. Typically, you can take multiple loans over the term of the loan, which is referred to as the “draw period.”
Many mortgage lenders will even issue you a HELOC card, much like a credit card, which gives you easy access to the money.
Taking out a relatively small amount, maybe between $10,000 and $20,000, might make more sense for a HELOC, especially if you have a great initial mortgage rate. You may have to refinance more expensively if you do a cash-out refinance.
Home Equity Loan
This is a second mortgage for a fixed amount, at a fixed interest rate, to be repaid over a set period.
It works in a similar manner to a mortgage and is typically at a slightly higher rate than a first mortgage. This is because if the home is foreclosed on, the home equity lender is behind the first lender in line for repayment through the sale of the home.
Consider a Refinance with Cash-Out If:
- You have more than 20 percent equity in your home
- Your home’s value has increased since you purchased the home
- You plan to use the funds to reinvest in the home or to pay down expensive debt, such as credit cards
- You can secure favorable new terms on a mortgage, like a lower interest rate and lower monthly payments
Risks to consider
There are advantages to taking equity out of your home, but there are also risks. The primary downside of a mortgage or equity product is that your home is used as collateral.
The result is that if you are unable to make your monthly payments for an extended period of time, your home may be repossessed (foreclosed).
A foreclosure will not only cause you to lose your home and all the equity you’ve built up, but it could also have the following repercussions:
- Your credit score could drop by at least 100 points or more
- A foreclosure will remain on your credit report for seven years from the date of the first missed mortgage payment
- A lender may not allow you to borrow money for several years. Generally, borrowers must go through a waiting period after a foreclosure before being able to qualify for a mortgage
- You could end up with a deficiency judgment, which is a court order allowing a lender to collect additional money from you. The lender could garnish your wages, put a lien on any other property you own, or levy your bank accounts