The strong rebound in home prices over the past few years may have transformed your home into a potential bank.
The average home price in the U.S. has risen 50% since 2011, and is now higher than the 2006 peak. So if you’ve owned your home for a while, there’s a good chance it’s worth quite a bit more than when you purchased it.
In the right circumstances, your home equity can be a good source for cash to pay for things like college tuition or home renovations, or lower the interest rate on your debt by consolidating the payments into a lower-rate loan.
That said, it definitely bears taking these loans with caution; like your mortgage, if you neglect to repay your home equity loan, you could lose your home.
Think it might make sense for you to tap your home equity? If so, here’s a rundown on the best type of loan to take—and how to get the best deal.
Your financing options
There are three main options for turning home equity into cash: a cash-out refinance, or taking a new mortgage for a larger amount and pocketing the difference, a home equity loan, or a home equity line of credit (HELOC).
Until recently, cash-out refinancing was popular, but as mortgage rates have risen over the past two years—from an average of 3.5% for a 30-year fixed mortgage to near 5% recently—refinancing makes less sense.
A home equity loan is a “classic” second mortgage with a fixed interest rate. With a loan you receive a lump sum payout and immediately begin paying it back; the typical repayment period can be 5, 10 or 20 years. The current average rate for a home equity loan is 6.75% according to Bankrate.com.
A HELOC is an open line of credit, typically for 10 years. If you use the line, you’ll need to start making interest payments right away, but you don’t have to start paying back the principal until that 10-year period ends.
Another difference: the interest rate on a HELOC is variable, not fixed. Your rate moves in sync with changes in short-term interest rates that are influenced by Federal Reserve policy. For the past three years, the Fed has been pushing short-term rates higher. The average initial rate for a HELOC today is 6.25%.
Banks are highly motivated these days to suggest HELOCs over home equity loans. Changes in federal regulations since the 2008 financial crisis has made it more expensive for banks to offer home equity loans, but not the cost of offering HELOCs.
“For technical, not sinister reasons, many banks have made the choice to just offer HELOCs,” says Keith Gumbinger, vice president of consumer mortgage site HSH.com.
What type of loan to get
If you intend to repay a home equity line or loan within a few years, a variable-rate HELOC may be the way to go. Your interest rate right now is almost a point below the average for fixed-rate home equity loans.
Plus, notes Gumbinger, the Federal Reserve is expected to push rates only another percentage point or so higher, meaning that the rate on the HELOC might only rise to where a home equity loan is today.
If you expect to take longer to pay back what you borrow, however, a fixed-rate loan can offer peace of mind that you will never face a too-big payment increase.
Many lenders also now offer a hybrid HELOC where the official initial rate is variable, but you can switch to a fixed rate. For instance, Chase offers a HELOC where you can convert 95% of your HELOC to a fixed rate when the loan closes, or you can wait and lock in fixed rates as you tap your line.
If you’re interested in a hybrid HELOC, make sure you understand how the lock-in feature works: the lock-in rate may or may not be the same as the rate on today’s variable loan.
In all cases, keep in mind that unlike mortgage debt, you can’t deduct interest on a home equity loan unless the money is used for home improvement. Also, lenders typically require that the
combined balance of your primary mortgage and your home equity line doesn’t exceed 80% of your home’s value.
How to find the best deal on loans
If you’re right at the 80% line, your best bet may be to work with the lender who is servicing your primary mortgage, as they may be more willing to make a deal for a current customer.
Regardless, it also pays to shop around and compare the cost of a traditional home equity loan with the lock-in rate offered on a HELOC. Bankrate.com has a database of HELOC and loan offers in your region.
You might also want to check credit unions, which often offer competitive loans. For example, anyone can join the Alliant Credit Union or PenFed Credit Union Both currently offer old-fashioned fixed-rate home equity loans with interest rates below 6%.