Forget that rags-to-riches hoopla about the stock market. Over time, the home
you own is a virtually risk-free investment offering a relatively stable and
reliable return on your money, compared to the more volatile stock market,
according to Federal Reserve research.
Homeowners who sell their homes averaged a net capital gain of more than
$25,000 in the last five years, the Fed says. Best of all, you don't have to
sell your home to tap its worth.
What would become capital gains if you sold your home is available right now
as what's called "home equity." (Home equity is the difference between what your
house is worth on the market and how much you currently owe on the mortgage.)
Though a growing number of lenders will let you borrow against all of your
equity and, in some cases more, most lenders will let you borrow money secured
by only on a majority of your equity. Generally your first mortgage, the one you
signed to buy your home, and any equity loans will total 70 to 90 percent of
your home's value, wisely leaving you with an equity cushion.
You have three basic equity loan choices. Each has its pros and cons. The big
pros, of course, are extra money to spend as you wish and tax deductibility you
can't get from a credit card. The big cons are the risk you take because your
home is on the line and some of what you borrow may not be tax deductible.
Here's a closer look at each.
Refinanced Mortgages: When you refinance your original mortgage, you
swap it for another, almost always because the rate of the new mortgage is
cheaper. If you refinance your existing mortgage, along with some or all of the
equity, you can then take out the equity as cash to use as you wish.
Pros: If your original mortgage's interest rate is higher than prevailing
rates or carries an adjustable interest rate that has been trending up, a
cheaper fixed rate can cost you less each month and you needn't worry about
future increases in your monthly payment. This could be true even if you take
out some equity, as long as the difference in interest rates is significant
enough and you don't use too much equity.
Also, if you made a low down payment on your original first mortgage and had
to pay private mortgage insurance, the refinanced mortgage could rid you of that
extra expense, provided your new loan is 80 percent or less than the value of
your home.
It's possible to opt for an adjustable rate that's cheaper than your original
mortgage's rate, fixed or adjustable, and pay less each month. Some home owners
who want to build equity more quickly refinance with a shorter term loan, of say
15 to 20 years, so that more of their monthly payment goes toward the principal.
Finally, compared to your other two equity tapping choices, this choice comes
with only one monthly payment.
Cons: A refinanced mortgage is more application-intensive then your other
options. The paperwork can be nearly as extensive as your original mortgage.
It's also the most expensive of your choices. The cost of a refinanced mortgage
can include points (each point is one percent of the financed amount) other loan
charges and escrow fees and time, nearly as much as your original loan.
Unless you cut the term to say to 15 or 20 years, a refinanced mortgage is
like starting all over again with a 30-year mortgage. When you refinance an
original mortgage and take out some equity, it's more likely your payments will
be higher than your original mortgage. If you can't afford the payments you
could lose your home.
If you choose an initially cheaper adjustable rate, to offset the possibility
of higher payments, you'll have to prepare yourself for the inevitable
adjustments upward. If you need to refinance for more than 80 percent of your
home's value, you might be better off considering your other options.
Home Equity Loans: With a home equity loan, also called a "second
mortgage" or "term equity loan" you don't touch your original mortgage, but
borrow cash against your equity, say to consolidate bills, buy home improvements
or send the kids to college. You get a lump sum you pay back in monthly
installments, usually for a fixed rate, over a fixed term, usually from 10 to 20
years.
Pros: Some second mortgages allow you to borrow money that will bring your
total indebtedness on your home up to 125 percent or more of its value. If you
can get all the cash you need in a market with rising values you'll be ahead of
the game. Available with competitive adjustable rates, these loans often come
financed with slightly more expensive fixed rates so you can depend on the same
payment each month.
Cons: Home equity loans rates can be one to several points more expensive
than interest rates on a refinanced mortgage. If you borrow more than your home
is worth you may not be able to afford the payments and you won't have any more
equity to tap should an emergency arise.
Also you won't get a tax write off for all the interest. Joint tax filers can
deduct all the interest on a maximum of $100,000 in home equity loans, according
to IRS Publication 936 "Home Mortgage Interest Deduction." The maximums are
halved for married tax payers filing separately and the deduction is actually
limited to the lesser of the $100,000 maximum and the home's fair market value,
determined by a complicated formula found in Publication 936.
Also watch out for second mortgages with large "balloon payments" (the last
one is more often blimp sized) and prepayment penalties.
If you're borrowing cash to pay for your kids' education some time in the
future, or for a long-term remodeling project, this loan probably isn't for you.
You'll be making payments right away for money you haven't spent.
Home Equity Lines of Credit: "HELOC" for short, home equity lines of
credit begin with a quick approval, few if any up-front costs and the lender
handing you a checkbook, credit card or some other method to access to your
equity money. Working much like a credit card, you dip into the till only when
necessary.
Pros: You don't get dinged for interest until you actually use your cash.
That's a handy financial tool to have, say, for a home improvement project you
pay in installments. You generally won't won't be saddled with a large
prepayment penalty if you only need the money for a short time. Low introductory
variable rates let you use money for less than if you opted for a fixed-rate
home equity loan. Other flexible features can be built into your HELOC. For
instance, if you pay off your balance your line of credit can remain available
-- without reapplying -- for the life of the line of credit.
Cons: Lines of credit can get expensive. HELOCs are almost always adjustable
rate loans with periodic interest rate charges continually applied to your loan
balance, much like a credit card. While the rates are much less than most credit
cards, they do "feel" like a credit card and temptation could cause you to use
it much like you use your plastic -- for every day shopping. Each withdrawal
could come with a fee and if you reach your limit you could be short should a
real emergency arise or it comes time to pay for a big-ticket item.
