Home values over recent years have recovered their losses and then some. Not only does this equity recovery allow homeowners to sell their homes without having to come to the closing table with additional funds to cover the mortgage, but to benefit from the increased equity in the property. Most borrowers who sell use the proceeds from the sale of the home to buy yet another property in which to live. Equity is the difference between the amounts owed on a mortgage and the market value of the home. If you bought a home for $200,000 and it’s now worth $225,000, that extra $25,000 is yours, not your lender’s. Homeowners don’t have to tap into that equity solely by selling the home but can access the equity in the home in two primary ways—a cash out refinance and a home equity loan. Let’s compare both options.
A cash out refinance occurs when the homeowners refinance an existing loan and pull out additional cash above and beyond the existing mortgage and closing costs. A rate-and-term refinance is a refinance where only the existing mortgage and closing costs are included in the loan. For instance, say a home is currently appraised at $225,000 and there is a $125,000 loan balance, leaving $100,000 in equity. Most conventional loans allow for up to 80 percent of the value of the home to be used as a cash out loan. In this example, 80 percent of $225,000 is $180,000. That’s $45,000 in available equity. If closing costs on the refinance are $5,000, the borrowers can take up to $40,000 in cash.
A home equity loan is a separate loan and not part of a cash out refinance. Different lenders may have different limits on home equity loans although a common “combined loan to value” or CLTV is 80 percent of the current value of the home. If the home is appraised at $225,000 and the current loan balance is $125,000, there can be a second loan in the form of a home equity line of credit, or HELOC. In this example, the HELOC could be as high as $45,000. The HELOC works much like a credit card. There is a credit limit and the borrowers can tap into that line of credit when they need it and can pay off the amount with regular monthly payments or all at once. A home equity loan can also be a second mortgage issued and cash is deposited into the borrower’s bank account with regular monthly payments made until the loan is paid off. So, which is better?
The interest rate on a cash out refinance will be lower than an equity loan. That means the monthly payment on the equity taken out will be lower with the cash out option. However, the cash out amount is added to the new loan and amortizes over the life of the newly refinanced loan. Closing costs are much higher compared to an equity loan—much higher. Closing costs on an equity loan are minimal. An equity loan payment is separate from the primary mortgage and while the rate is higher, the loan can be paid off separately from the first mortgage.
If a homeowner simply wants to tap into the equity of their home and they’re satisfied with their existing mortgage, an equity loan is the best choice. If borrowers are refinancing an existing loan to get a lower rate or change from an adjustable rate to a fixed and then it might make sense to pull a little equity out in the form of cash. Both are good options, just have a good conversation with your loan officer so you completely understand your choices and the impact of each.
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