I frequently get calls from clients that are in need of extra cash, and are looking for the right mortgage product. The two most popular mortgage solutions are, a Cash Out Refinance or a Home Equity Line of Credit (HELOC). They are not the same, and what works for some does not work for all.
Let’s look at these two solutions, and see what the ins and outs are.
A cash out refinance mortgage loan is a great option if you have accrued a lot of equity in your home. For example, if you originally took out a loan of $225,000 a number of years ago, and you still owe $125,000 on a home that is worth $500,000, you could refinance the amount you owe and add the amount you need in cash against the equity in your house. The money can be used to consolidate debt, do a remodeling project, or even invest. It is usually a fixed rate unless you opt for an adjustable.
As great as a cash out refinance can be, there are a few things to think about before you decide to take out this type of loan. For example, you will be paying closing costs on the entire amount you borrow, which includes the remaining balance of your current mortgage plus the additional cash you are taking out.
Does that mean a cash out refinance is not the right solution for you? The answer is, maybe yes and maybe no.
Let’s look at the most popular alternative, the HELOC. This is a line of credit that is tied to the prime rate (currently five and a half percent) plus a margin that the lender will usually add to that rate to come up with the rate you will be paying. It is an adjustable rate, in that it will change as the Fed adjusts interest rates that cause the prime rate to increase or decrease.
You make monthly payments on the amount you actually take out on the available line of credit. There is usually an initial draw period of 10 or 15 years when you can make withdrawals, during which you will pay interest only. After that, you will enter the repayment period of the loan for the last 10 or 15 years, when your payments will include principal and interest just like a traditional mortgage loan.
OK, so which loan is best for you? There are pros and cons depending on your individual situation.
Let’s say you need $100,000 to improve your home for enjoyment and to add value. In the example above, your house is worth $500,000 and you owe $125,000. Your current interest rate is 4.50 percent. With a cash out refinance, you would take out a new first mortgage of $225,000 plus closing costs (let’s use three percent or $6750) for a new fixed rate first mortgage of $231,750 at about 4.75 percent using today’s mortgage rates. Your monthly payment going forward will be $1208.92 for principal and interest for the life of the loan.
On the HELOC side, you would keep your first mortgage of $125,000 and add the HELOC of $100,000 (assuming you will take all the money out) to do the construction. Using a typical margin of one percent, you will start out at a rate of 6.50 percent paying interest only for the first 10 or 15 years (the draw period). So your monthly payment will be your current payment for principal and interest on your original mortgage of $1140.04 plus your new interest only payment of $541.67 for a total of $1681.71.
The variables for the above example can be totally different in your case, so don’t get too focused on the numbers. It’s the principals of the two loans that are the takeaways here.
If you currently have a great first mortgage rate and you still owe a substantial amount of money and you only need $50,000 or less, I would opt for the HELOC because it’s just not worth giving up your great first mortgage rate and pay closing costs on the full amount of the new mortgage.
On the other hand, even if you have a great first mortgage rate but you don’t owe that much more and you need a substantial amount of money, then it makes sense to look at a cash out refinance. The reason is, because although you will be giving up a great first mortgage rate it is only for a small amount, and although there are closing costs on the refinance, almost everything else works to your benefit.
With the HELOC, the rate is tied to the prime rate, which most economists say will continue to increase over the next number of years. Not only will that increase your interest only payments during the initial draw period, but in 10 or 15 years you will add principal to those payments, and if the prime rate is up at say nine percent (a rate I have seen in my mortgage career), you can be paying as much a 10 percent for principal and interest in the future.
Just to recap, the factors that should guide your decision are, how much you currently owe on your first mortgage, what is your current interest rate, how much are you looking to borrow, the HELOC rate plus margin, the draw period for the HELOC, the costs of each type of loan, fixed rate vs. adjustable, and the direction of interest rates in general.
As you can see, there are a lot of factors to consider and you probably will need a mortgage professional to crunch the numbers for you and help you decide. If you need my help, feel free to contact me.
Taking cash against the equity in your house can be a wise move, but always compare taking a cash out refinance mortgage loan against the option of taking out a HELOC and choose the plan that is best for you.
Lester Bleich, New York State Licensed Mortgage Loan Originator 