Home Equity: How You Can Use It

Financing

Do you know the difference between a second mortgage and a home-equity loan?  How about the difference between a home-equity loan and a home equity line of credit? And, is a mortgage refinance similar to the above, or a different animal altogether? Let's take a closer look at all the various ways you can use your home equity – without fear of losing your home or getting taken for a ride.

First of all, a second mortgage is basically the same thing as a home equity loan. Each of these terms refer to money that is borrowed against the value of your property. Many people don’t realize that these loans are liens against your property – in other words, if you default on the loan, the lender then takes ownership of your home. You forfeit your house in order to pay what you owe. It’s not like a credit card payment that you can skip when things get tight and just make up with extra interest later.

Now let’s look at the different ways you can use your home's equity, which is the difference between the market value of your home and what you owe on it.

Refinance: In essence, this is a way of paying off your current mortgage and getting cash out based on how much equity you have in your home. This is a great way to lower or lock in your mortgage interest rate, and it is a way to get large sums of money – $30,000 or more – because you will have 15 to 30 years to pay it off. Use caution, however, because some lenders may offer to lend up to 125% of your home’s value.  Should you default on paying this new loan, you may still owe money even after your house has been repossessed! Plus, the mortgage interest is tax deductible only on 100% of your home’s value, meaning you cannot claim any interest you pay on the overage.

On refinances, you may have to pay closing costs, discount points, appraisal fees, application or loan processing fees, document prep and recording fees, origination or underwriting fees, lender or funding fees, loan broker fees, and miscellaneous other fees (i.e. overnight mail charges, etc.) You can negotiate all these fees, and lenders sometimes offer “no-cost" loans where the fees are rolled into the mortgage balance or absorbed by bumping up the rate. If you borrow 80% or more of your home’s value, your lender will require you to purchase private mortgage insurance.

A home equity loan (a.k.a. second mortgage) is good for homeowners who don’t need quite as much cash and whose interest rate is already competitive. The interest rate on a home equity loan is usually fixed and based on the prime rate, so it’s higher than regular mortgage rates, but the term is only 5-15 years, much less than a conventional 30-year mortgage. Closing costs are much less than a refinance. These installment loans are paid out in one lump sum and can be used for repaying credit card debt or any other high-interest, high-dollar fixed sum of money owed. They’re also one of your best bets for small to large remodeling projects.

You might even want to use a home equity loan for buying a new vehicle. Proceed with caution, however. You must be sure you will be able to pay this loan back, because you are putting your most valuable investment, your home, at risk. It is easier to foreclose on a second mortgage (even though the amount is less than the home is actually worth) than on a federally insured first mortgage, and you should commit yourself to shopping around and educating yourself. Find out about closing costs and points, balloon payments, hidden fees, or credit or property insurance in advance.

The home equity line of credit works similar to a credit card – you agree to a pre-set limit and then borrow from it as you need to, or in the event of an emergency, then pay it down and possibly use it again. A HELOC lets you tap into your home's equity as needed, usually for up to 10 years. These lines of credit are good for expenses like debt consolidation, major home improvements, college tuition and expenses, or any type of unexpected expenses. The beauty of this type of loan is that you don’t make payments unless you use the money, but you have the security of knowing money’s there if you need it.

Some lenders may offer a lower interest rate if you pay points up front so be sure to ask about this option. Rates are usually variable, based on the prime rate plus some margin, and many offer low teaser rates for the first six months. There may be an annual fee of $30 to $75 after the first year.

And now for the caveats: some credit lines have variable interest rates with no cap on how high they go. Make sure you read the fine print and find out exactly how much it could increase, then be sure to do the math. Could you afford it, and would you even want to? If you’re an impulse buyer who may be tempted to max it out quickly, this may not be a wise choice. A home equity line of credit shouldn’t be used for frivolous luxury items, unless it’s a one-time purchase and not a pattern of repeated behavior.

So there you have the skinny on ways you can use the equity in your home.  Be sure to explore all your options and the repercussions of each before signing on the dotted line.