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What’s Better? Cash out refinance or home equity loan?

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You don’t hear a lot about people taking out home equity loans these days. With all the millions of homeowners who got in financial trouble by using their homes as “ATM machines” to support their lifestyle and the recent massive declines in home values, home equity borrowing has both gotten a bad rap and become much more difficult to obtain.

But many homeowners find they still have a need for such loans, to fund major and necessary expenditures, particularly home repairs or renovations that enhance the value of their property.

Just as important, such loans are still available for the millions of homeowners who still have equity in the property despite the declines in housing values the past three years.

Generally speaking, homeowners have three major options for borrowing against their home equity – a cash out refinancing, a home equity loan or a home equity line of credit (HELOC).

Homeowners aged 62 and above have a fourth option, known as a reverse mortgage, but those are beyond the scope of this article.

Each has its advantages and drawbacks, depending on the circumstances and needs of the borrowers.

Cash out works for those already refinancing
For homeowners who are already thinking about refinancing their mortgage to get a lower interest rate, a cash out refinance will probably make the most sense.

In a cash out refinance, you simply take out a new mortgage to replace your current one, but borrow more than you owe on the existing mortgage.

The excess is received as a lump sum that can be used for any purpose you wish – you don’t have to submit a plan justifying your need for the additional money, though the lender may ask what the general intent is.

A cash out refinance will generally give you the lowest interest rate of all home equity options and the widest choice of loan types as well – fixed rate, adjustable rate, loan terms of 10 40 years, etc. It also means you only have to deal with one payment a month – no separate payments for your mortgage and home equity loan.

On the downside, the closing costs for a cash out refinance are considerably greater than those on a home equity loan or HELOC – closing costs are based on a percentage of the loan amount and you’re refinancing the entire mortgage. You could end up extending the term of your mortgage unless you choose a loan scheduled to be paid off on approximately the same schedule as your current one.

Lower costs on a home equity loan
With a home equity loan, your current mortgage stays in place. Instead, you simply take out a smaller loan just for the amount you wish to borrow.

Closing costs are much lower than on a refinance, because they’re based on a smaller loan.

A home equity loan also allows you to keep your current rate on your existing mortgage, which may be an advantage if rates have risen since your first took out the mortgage.

Your interest rate on a home equity loan will be higher than on a cash out refinance, but lower than the initial rate on a HELOC.

The term on a home equity loan is typically fairly short, no more than 10 years. So your total monthly payments are higher than they would be on a cash out refinance, though you’ll pay off the extra amount faster.

You’ll also have two monthly mortgage payments, one for your regular mortgage and the second for the home equity loan.

HELOC provides convenience, flexibility
With a home equity line of credit, you’re not actually borrowing any money right up front, you’re simply arranging to borrow up to a certain amount as needed, in whatever increments you desire.

This can be convenient if you’re planning several separate projects or if you need to make multiple payments to a contractor over the course of a project.

You only borrow what you need, when you need it. HELOCs often provide checks or debit cards that can be used to draw on the account as needed, adding a measure of convenience.

A HELOC provides more flexibility than a cash out refinance or home equity loan. For example, if you set up a $35,000 HELOC and only borrow $25,000 against it, that’s all you pay interest on.

But if you borrow $35,000 in a cash out refinance or home equity loan and only end up needing $25,000 of it, that’s an additional $10,000 you’re paying interest and closing costs on.

On the other hand, if you borrow $25,000 through a cash out refinance or home equity loan and end up needing more money, you have to arrange for yet another loan.

HELOCs also come with little or no closing costs. However, their interest rates are substantially higher than on refinances and home equity loans, and are variable as well, so you could see your payments increase substantially.

Like home equity loans, their terms tend to be relatively short, so they need to be paid off faster than a full blown refinance.

Because they are open ended and convenient, some borrowers succumb to the temptation to draw on them for noncritical expenses from time to time, piling up debt they may not have incurred if they’d just borrowed a single lump sum.

Tax deductable interest
One thing all three types of loans have in common is that interest paid on them is tax deductable – as long as they’re drawn against your primary residence and your total mortgage debt doesn’t exceed the market value.

However, there can be complicating factors if you also have a mortgage on a second home or investment property, so borrowers in those circumstances should be sure to consult with their tax adviser first.

Qualifying for any type of home equity loan in the current economic environment may be challenging.

Lenders will likely require that homeowners retain at least 20 percent equity in their homes in addition to any home equity loan or line of credit, and will insist on excellent credit as well.

In addition, homeowners in areas where prices have seen unusually steep declines and remain unstable may have difficulty getting a home equity loan regardless of their personal qualifications, though this may change as credit markets gradually improve.


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