Michoel Seewald was in a quandary. He had tons of equity tied up in his family home and an investment house. With his daughter’s wedding coming up, he wanted to take some profit out of his house to cover the bills. He also wanted to use some of the equity of his investment house to buy another one.
What are his options to tap into home equity without selling?
House Rich, Cash Poor
It is quite common for Americans to be house rich and cash poor. As values rise, homeowners often find themselves with a lot of equity which they may want to access, but selling solid real estate is usually undesirable. If it’s a family home, it’s obvious that selling just for a bit of cash isn’t wise, but selling investment property is also not simple—there are significant cost and time burdens involved in selling real estate as well as taxable gains and depreciation recapture to manage. Instead, savvy real estate investors use various loan options to unleash illiquid wealth.
Cash Out Refi
One option is the cash out refinance. When people begin their loans, they typically borrow around 80% of the value of the home after putting down 20%. As home values rise and principal repayments whittle down the outstanding loan, a spread opens between what lenders will allow you to borrow and what is owed. As long as their income can comfortably cover the new mortgage payments and their credit is decent, homeowners can refinance their mortgage to take out equity to pay bills, invest, etc. These funds are not taxable as they are loans, not locked-in gains.
Cash out refinances work well when the interest rates available for the refi are similar to or lower than the rates locked into the current mortgage. But if mortgage rates have risen, it’s probably a bad idea to walk away from the benefit of many years of more affordable monthly payments just to access some cash. At the time of this writing, many homeowners have mortgage rates locked in the low single digits, and refinancing can easily double the interest rate they’d have to pay on the entire outstanding balance, not just the cash being tapped. Not good.
Home Equity Loans
This scenario is where another mortgage option, home equity loans (HEL), can shine. HELs are second mortgages loaned against the home by a new lender on top of the original mortgage. With HELs in place, homeowners make two mortgage payments every month—the original monthly payments they had been making and a new monthly payment toward the HEL.
Because they are in a weaker position in case something goes wrong, HEL lenders charge higher rates for shorter terms than first mortgages.
The Numbers Make Sense
It’s unpalatable to have another monthly mortgage payment, especially at a higher rate. But running the numbers shows it can make perfect financial sense. Say, for example, someone’s current mortgage has $400,000 outstanding locked in at 3% with 240 monthly payments of $2,218 still due. He needs $50,000 and is weighing a cash out refinance versus a home equity loan.
A cash out refinance of $50,000, totaling an outstanding balance of $450,000, financed in one 20-year mortgage at 6% raises his monthly payments to $3,223. This means his maneuvering adds an extra $1,000 cost for the remaining 240 months. But if he keeps the original mortgage and adds a 10-year HEL loan of $50,000 at 8%, his added cost for payments on the HEL would be just $606, with both payments totaling $2,824—less than the cash out refinance. And the extra HEL payments run for just for 10 years, not 20.
Another approach is setting up a home equity line of credit (HELOC) against the value of one’s house above the first mortgage. HELOCs provide backup funding for personal or business needs. Like a home equity loan, a HELOC is a second mortgage, but unlike home equity loans, you don’t pay interest on a HELOC until money is drawn down; you only pay interest for what you draw, and you can repay it as money becomes available. Then, the HELOC availability sits there for the next time you need some quick cash at a reasonable rate.
There are downsides to HELOCs’ flexibility. First, HELOC interest rates tend to be adjustable, which can mean a lower rate versus a home equity loan at first, but the percentages can skyrocket unexpectedly. HELOCs usually offer lock options once you draw the money, converting a HELOC into a home equity loan, but you need to pay attention to this crucial detail. Also, banks have also been known to shut down HELOCs during times of crisis or if they think the value of the house has fallen. That may be the very time you most need access to your home equity!
Bottom line, you can tap into home equity without selling and incurring taxes or brokerage fees or giving up a good first mortgage rate. Note, however, that as with any mortgage, there will be costs such as points, appraisals, and legal. Most mortgage brokers don’t deal with HELs or HELOCs, so you will need to shop around yourself. You still need to prove to the lender that you fit in their “box” as far as credit scores, income, loan to value, etc. And the many programs offered to first-time home buyers won’t be available to you this time around.
A House isn’t an ATM
Aside from the costs of tapping home equity, it is important to consider the risk of piling debt onto a stable property, especially if it’s the roof over your family’s heads. Tapping into home equity may also lead to overconsumption. Some people continually refinance to cover excessive spending and head into retirement burdened by massive mortgages instead of a trove of home equity to support their silver years. On the other hand, home equity is far less costly than credit cards, and there may be no alternative for those in a financial crunch. Borrow savvily.