Understanding Home Equity Loans and Cash-out Refinance
A home equity loan can be a great way for servicemembers to take cash out of their homes, whether it’s for college tuition, to finance a renovation, or to pay down credit card debt. The recent financial crisis and collapse of the real estate market brought this type of lending to a halt, but there are signs that it’s picking up again for qualified homeowners. However, it’s not always the right answer to your money needs. Here are some tips that will help you identify the right time and ways to use home equity loans:
1. Learn the home equity basics.
Make sure you learn the fundamentals of home equity before jumping into the fray. There are two basic types of home equity products -- a home equity fixed rate loan and a home equity line of credit. A home equity fixed rate loan is a fixed rate second mortgage dispensed as a one-time lump sum with a typical repayment term of 5-15 years. A home equity line of credit (HELOC) is a variable rate loan tied to the Prime Rate.
There are pros and cons to each. A home equity fixed rate loan affords homeowners a consistent payment and protection against rising interest rates, but may have higher rates overall. A HELOC can have a lower interest rate than a fixed line, and you only draw as much as you need, but rates are unpredictable and may rise. (Follow this link for information about home equity loans and lines of credit from Bills.com.)
2. Consider a VA cash-out refinance loan.
The VA offers an equity-based option specifically for servicemembers called a “cash-out refinance” loan, which allows you to refinance your current home loan for a low, fixed interest rate and take out the cash you need, up to a certain amount. It’s not a second loan, but a refinance of your current one. Because the government guarantees these loans, they are generally cheaper than refinancing options available to civilians, but they still carry many of the same risks as home equity loans and lines of credit because you are taking on more debt and losing equity in your home. Depending on your needs, you may find that traditional home equity loans and lines of credit offer more cash or more flexibility.
3. Evaluate the impact of inflation, interest rates, and home value.
Rising inflation, increasing interest rates and declining home values can impact a loan and make it less affordable. For example, with mortgage interest rates continuing to hover around historic lows, it is likely that rates will increase over the coming year, which will make a HELOC more expensive. A weaker dollar can also make it more difficult to afford an additional mortgage note, especially a variable-rate mortgage. And finally, by removing equity from your home through a home equity loan or line of credit, you will be particularly vulnerable if home values continue to decline.
4. Evaluate the risks of secured versus unsecured debt.
Home equity loans and lines of credit are secured debt, which means you use belongings like your house or your car as collateral. While this type of debt can be less expensive than high-interest, unsecured credit card debt, it carries certain long-term risks. Quite simply, if you can’t make your payments, you could lose your house, car or other assets. If you are considering using a home equity loan or cash-out refinance to pay off credit card debt, understand that you are trading unsecured debt for secured debt. If you find yourself unable to make these new payments, you are at risk for losing your home. This could easily be the case if a variable rate HELOC begins to rise with interest rates or you find yourself fighting back inflation by shorting your monthly payments. Be sure to consider all the options and understand all the implications before using a home equity product to reduce unsecured debt.
5. Know if you qualify.
Simply because banks are once again extending home equity loans does not mean every homeowner will qualify. You should first understand how much equity you have remaining in your home. Generally, banks will still require at least 20 percent equity in a home. If you bought your home without a down payment -- which a VA loan allows you to do -- then it may take even longer to build up sufficient equity for a home equity loan. You could also be denied if your credit score is too low. Potential borrowers should expect to meet strict minimum eligibility requirements that normally include a 720 credit score and verified income for the past two years.
A home equity loan or a VA cash-out refinance can be a great way for servicemembers to pay for large expenses by tapping into the value of your home. If you think it’s the right step for you, talk to your accountant, financial advisor or a VA-approved lender to learn about your options.
Ethan Ewing manages Bills.com, a website business which provides practical financial advice and resources to everyday people. Prior to joining Bills.com, Ethan was a Vice President for Experian Interactive, a leader in online marketing and advertising, where he was responsible for developing online partnerships with many of the internet's largest properties. Ethan has also built a website business for Ameriquest Mortgage, managed a mortgage origination operation and consulted on secondary market bulk mortgage acquisitions. Ethan received his BA from Denison University, where he was a captain of the men's lacrosse team.
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