3 ways to tap home equity

Not all homeowners are being smart about cashing in on rising value

Your Money

July 25, 2004|By Lorene Yue

Much of the consumer spending boom of the past few years has been fueled by Americans tapping into the equity in their homes, but not everyone may be getting at their money in the smartest way.

There are three ways to turn the equity in your home into cash: refinancing your mortgage, taking out an equity line of credit or getting an equity loan.

Each has its pluses and minuses. Both home equity products can have closing costs, although they are usually much smaller than with a first mortgage. In some cases, lenders may waive closing costs for home equity products or roll them into the amount you are borrowing.

Consider refinancing if the interest rate on your mortgage is higher than the going rate. If you've got a low rate that can't be beat, you'll want to look into the other two home equity products. But don't confuse the two.

"A lot of consumers use the phrases interchangeably," said Ron Chicaferro, senior vice president for Thornburg Mortgage Inc. of Santa Fe, N.M. "They are not quite sure what it is that they want because both programs have the word equity in them."

Think of the home equity line of credit and a home equity loan as fraternal twins - both born from the same concept but each with different traits. With a line of credit, you can borrow money in dribs and drabs as you need it, as long as the total doesn't exceed the equity you have in your home. A loan gives you a one-time distribution with a set repayment schedule.

Borrowers seem to be more interested in the line of credit because of its flexibility, said Dave Herpers, director of consumer affairs for Amerisave Mortgage Corp. in Atlanta. "If someone needs $20,000 today and they have $50,000 in equity, it doesn't cost them more [to borrow more money later]," Herpers said. "Why get $20,000 if you can't get additional funds for the next 10 years without refinancing?"

But your choice also depends on how much risk you can stomach. Home equity loans typically have a fixed interest rate and limit you to how much you can borrow at one time.

Home equity lines of credit usually have a variable rate, which means the rate moves in conjunction with the prime rate. You might be better off with a home equity loan if you worry that rising interest rates will bump up your payments, or if you aren't good at controlling your spending.

Also, if you have a heavily blemished credit record, you might not qualify for a home equity line of credit.

Here are other differences:

Liens

Both the line of credit and loan will create a second lien on your home, unless you have already paid off your first mortgage. If that's the case, then they become the first lien. The difference is the amount of the lien. With a home equity loan, the lien amount is equal to the money borrowed. Take out an $80,000 home equity loan and you'll create an $80,000 lien.

With a line of credit, the lien amount is revised based on how much money you have tapped from available funds. If you open an $80,000 line of credit, but only use $5,000 to start, your lien is $5,000. If a month later you use another $5,000, your lien is revised to $10,000.

Ready access

A home equity line of credit comes with either a checkbook or credit card so you can tap funds whenever you want. Say you have $20,000 worth of equity. You could start by taking out $5,000 from the line of credit and then another $5,000 later in the year.

Home equity loan funds are distributed in a lump sum at the time of closing. If you need more money, you have to refinance your current loan or apply for another home equity product, assuming you still have equity left in your home.

Loan terms

"Read the fine print and learn what all the factors are," warned Susan Hirshman, planning strategist for J.P. Morgan Fleming Asset Management in New York. Find out if you'll get hit with a prepayment penalty, if any fees are charged for letting a line of credit go dormant and how much they can jack up the interest rate each year and over the entire borrowing term.

Two phases

There are two parts to a home equity line of credit - a draw period and a repayment period. During the draw period, which could be five to 10 years, you can take out funds and make interest-only payments. Once you hit the repayment period, usually 10 to 20 years, you no longer have access to your funds and you must make principal and interest payments.

"Typically, we see people refinancing at that point, either into a new line of credit or they roll it into their first mortgage," Herpers said.

There is no draw period with a home equity loan since you get the funds in one lump sum, and payments include principal and interest.

Tax advantages

Here's where both products are the same. In most cases, interest on the home equity line of credit and home equity loan is tax deductible. Check with the Internal Revenue Service for limitations on income and amount borrowed.

Lorene Yue is a Your Money staff writer.

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