Purchasing a house is the biggest investment decision for most of the households. It takes a long time to pay off the mortgage. However during financially difficult times or during emergencies one can use this investment to shore up the finances of the house. The longer one pays the mortgage; the greater is the equity in the house (not the case when home values drop significantly). This equity can be used to meet the immediate requirements. However, it has both its advantages and its pitfalls.
There are three general ways of using the equity in the house:
Home Equity Line of Credit (HELOC): This allows the household to have a line of credit against the equity they have in their house. This line of credit can be used as a general credit card. It is mostly for a limited time and a given amount. The ideal case can be Financial difficulty like temporary unemployment, paying for college education of children or minor expenses over an extended period. The interest rate charged on this loan is variable and is set according to the prime rates prevailing in the market. The loan can be taken for as long as 20 years, and the basic requirement is that the interest payments be regularly made for the amount of credit used.
In the early part of the last decade, the popularity of HELOC had increased because of the higher house value and easier terms offered. However after the financial recession most of the lenders require a good credit score, upwards of 720 and have more stringent terms.
Figure: HELOC debt outstanding in the economy in the past decade
Scenario: Matt and Jane Taylor own a house on which they had taken a mortgage of $150,000. Currently, they owe $50,000 on the mortgage. They are facing a little cash crunch currently and would like to use the home equity they have built in their house to sail through this period. They currently have $100,000 equity. They choose to go for an HELOC of $50,000. They used $10,000 in the first year for household repairs and other expenses. In the second year, they used another $15,000 towards household expenses and used another $15,000 in the third year. By the fourth year, their financial situation was back on track, and they did not require any further use of HELOC. They took the requisite amount at the beginning of every year. HELOC is charged at the prime rate which stays stable at 4.5% in this case. The loan has a 20-year term and a ten-year draw period. This means that the couple can draw at any time part or full amount within the ten-year period. During this time, they need to pay back the interest only for the amount withdrawn. After the draw period of ten years, the loan becomes self-amortizing where the interest and principal payment are required every month.
Interest and Principal payment:
First year: Interest payment = $10,000*4.5%=$450/year or $37.5/month
Second year: Interest payment = ($10,000+$15,000)*4.5%=$93.75/month
Third year: Interest payment = $40,000*4.5%= $150/month
They can either continue to make interest payments within the draw period of ten years or they can pay back the entire principal whenever they are comfortable within the given loan period. After the draw period is over the loan repayment requires both interest and principal repayment.
Home Equity Loan: This is a bit different from HELOC. Here the entire loan is given in one go and it is to be paid back over a period. The house serves as collateral when this loan is taken. This loan is taken by households when they are aware of the exact expenses. Some of the general cases are Medical emergency, house repair, specific investment.
The benefit of this loan is that the interest rate is fixed whereas in HELOC it is variable. This allows the household to chart the budget exactly knowing beforehand the payments to be made. The term for this loan can exceed to 15 years or may be kept to a shorter term. This is also called a Second Mortgage.
Currently, the interest rates are at a historically low point. Many households have shifted their HELOC to a home equity loan thus fixing their interest rate.
Scenario: Sam has a house on which he took a mortgage of $200,000. Currently, he owes $80,000 and has $120,000 equity in the home. He intends to purchase another property and requires $40,000 as down payment. He uses home equity loan on his first house and takes a loan of $40,000 on which there is a fixed rate of 4.5%. He has kept the term for this second mortgage as 15 years. This requires an additional payment of $306.00/month. This is a fixed payment.
In this case if the investment is sound and if Sam has done adequate financial homework it can be a boon to utilize the equity in the house. The requisite payments on this second mortgage are fixed which makes financial calculation of the future much easier. Also, the interest payment is tax deductible that makes the use of this loan much better than other investment vehicles. However, any delinquency from his part could potentially cause the foreclosure of his house or at least a major downgrade of his credit rating. Hence, these major decisions should be backed by thorough research and calculation.
Cash out Refinance: This is used to extract the equity in the house. A simple example can explain the concept: Jack and Mary Smith purchased a house in 2005 for $160,000 and got a mortgage of $140,000. They have been regularly paying and owe $100,000 by 2014. They want to have $30,000 for emergency medical procedure for Jack. They do cash out refinance of the loan and take a NEW mortgage of $130,000 for 30 years. They pocket the difference of $30,000 that they use for the medical procedure. This is different from home equity loan because this is a refinance to take a new loan whereas home equity loan is a second mortgage on top of the first mortgage. Negative is that it will have additional closing cost which can run into hundreds or thousands of dollars. The advantage is that the mortgage payment will be evenly distributed for the next 30 years whereas in home equity loan the initial double mortgage payments will be higher.
Comparison:
| Home Equity Line of Credit (HELOC) | Home Equity Loan | Cash out Refinancing | |
| Interest Rate | Variable | Fixed | Fixed |
| Amount | Amount can be withdrawn according to requirements till the given limit before the draw period. | Fixed amount disbursed when the loan is taken. | Older mortgage is cancelled and new mortgage is made. The difference in the amount is disbursed to the buyer. |
| Costs | Low closing costs | Low closing costs | High closing costs because a new mortgage is given. |
| Time and Effort to get the loan | Very easy for low amounts. | Easy depending on the loan amount | A new mortgage is made and hence the entire procedure of appraisal, document filing, checks, etc. will be made. |
| Repayment | Interest only repayment available for the initial years thus requiring minimal payments in the beginning. | Payments on the first mortgage as well as the second mortgage are required. Both are interest and principal payments. This requires the maximum payment initially. | New mortgage structure might reduce the payments depending on new interest rates and term of loan. It is self-amortizing loan. |
Needless to say that although it has several advantages and is a major backup for many households, taking an HELOC, home equity loan or cash out refinance has its pitfalls. The biggest disadvantage of this process is that it gives many households the illusion of easy money. Using these it is possible to find quick finance for any requirement. However, if chosen for the wrong reasons it can lead to a major decrease in the equity of the home and reduce any backup for future. Many times households have taken these loans for a vacation or to get a better car. These superfluous expenses should not be made with the equity in the house especially since the worst case scenario of it is foreclosure.
http://portal.hud.gov/hudportal/HUD?src=/program_offices/housing/sfh/hecm/hecmhome
http://portal.hud.gov/hudportal/HUD?src=/program_offices/housing/sfh/hecm/hecmabou
http://www.consumer.ftc.gov/articles/0192-reverse-mortgages