You own your own home and have some equity built up, but now you want to make some major improvements. Can you use your home’s equity to fund them? Yes! The good news is that you have options, but there is no “magic bullet” that’s right for everyone. Each option has its benefits and drawbacks. Let’s take a look.
Home Equity Line of Credit
A home equity line of credit (HELOC) is arguably the least expensive and easiest way to access your home equity, but it has one major disadvantage: HELOCS always carry variable interest rates. They are based on the Prime Rate and your interest rate can adjust every month (but usually doesn’t).
The advantage is that they are inexpensive to get, and you only draw out what you need to do the improvements you want, so you only pay interest on what you’ve borrowed — and not until you’ve borrowed it.
Brokers and mortgage lenders are rarely the best sources for equity lines, unless you are doing them in combination with a new mortgage. Large banks tend to be easy to work with, but the best source for this type of loan is almost always small community banks or credit unions. They tend to have the lowest fees and lowest overall cost.
One quick shopping note: Beware of “introductory” rates. Many banks offer lines of credit with a very low start rate (when you tend to owe very little on the line) and then increase the rate later on when it matters more, because you owe more. How do you know?
The most important thing to ask about a HELOC is the margin. This is added to the Prime Rate to determine your interest rate each time it adjusts. The higher the margin the higher your interest rate will be for the life of the loan. Be sure to ask what the permanent margin will be.
Home Equity Loan
If you don’t like the idea of a variable interest rate, get a fixed-rate home equity loan. These are usually written as a second mortgage and have payback terms from 10 to 30 years. The interest rate tends to be notably higher than a conventional first mortgage and higher than the start rate of an equity line, but you know what your interest rate — and your payments — are going to be.
The most common source for home equity loans tends to be finance companies referred by your contractor. They also tend to be the most expensive, by far. By all means talk to them because they tend to perform quickly, but do some comparison shopping, preferably at your local community bank or credit union.
If you have an existing fixed-rate mortgage with a large balance and a very low interest rate, and you don’t need to borrow much to accomplish what you want to do, then refinancing with a cash-out mortgage is probably not your best option. However, if your loan has an adjustable rate, or if you owe very little but need to borrow quite a bit to do the work you want to do, a cash-out refinance may be your best option. The blended interest rate, or the total interest you are paying between the two loans, might be lower with a cash-out refinance than if you kept your first and took out a second mortgage.
The best source for a cash-out refinance is almost always a local mortgage broker or small mortgage lender. Brokers in particular have access to dozens of lenders and pretty much every loan program in the country, and can shop for the best deal for you. Their fees will be about the same as going directly to banks or national lenders, but your interest rate is likely to be lower and you are likely to get better advice about which program and lender best suits your needs.
Avoid This Mistake
Time and time again, I see clients fund improvements via loans with terms that last longer than the planned life of the improvement. Why is this a mistake? Because when the item wears out, you’ll still be paying for it, and you’ll have to borrow again to buy another one.
For example, kitchen appliances might last 15 years. If you pay for them with a new 30-year mortgage, you’ll have paid off about 1/3 of the cost of the appliances when you need new ones. We call this lifetime financing.
Think carefully about the improvements you are making and how you intend to pay them off. Take out the lowest-cost loan, but have a plan to pay them off before they wear out.