The Difference Between a HELOC, Second Mortgage, or Cash Out Refinance
If you are shopping for a home equity loan, it pays to shop around. There are multiple lenders who may be eager to offer you a home equity loan. The loan officer may steer you towards the product which is best for him or for the lender, the loan that brings him the highest commission or the lender highest fees. This is why it is vital for you to be an educated consumer. You should know your priorities. What is most important to you? Is it finding the lowest monthly payment, the lowest interest rate, the highest loan amount, paying the least in fees, or some other goal? Once you've figured what your needs are, you make it easier on yourself to shop around in an effective manner.
HELOC, Second Mortgage, and Cash Out Refinance Pros
A HELOC, or home equity line of credit, is a flexible loan with a variable interest rate that allows you to take out as much or as little money as you need with a debit card or checks.
- Flexibility is perhaps the greatest advantage of a HELOC. Because you can use as much or as little as you need at any given time, you don't have to take out a loan that is too big for you.
- If you know you'll need extra money on a reoccurring basis, such as for tuition or an ongoing home improvement project, you should look into a HELOC.
A Home Equity Loan (HEL) second mortgage and a cash- out refinance are traditional loans where the money you borrow comes to you in a lump sum. In both HELs and cash-out refis, your lender disburses the funds to you when the loan closes. HELs usually have a fixed interest rate. HELs do not replace your current mortgage.
- If you get a fixed interest rate HEL, you know what your monthly payment will be for the life of the loan. While you can generally get a lower interest rate, if you get an adjustable rate mortgage, it comes with unpredictable payments. Any time you take out an adjustable rate mortgage, make sure to consider whether you can continue to afford the monthly payment that would come with a higher interest rate.
- A HEL or HELOC could be a good choice for you, if you do not want to change your current first mortgage or if the presence of a pre-payment penalty on your first mortgage makes refinancing it too expensive.
- HELs or HELOCs can be a way for you to borrow more than 80% of your home's value while avoiding private mortgage insurance.
In a cash out refinance, you refinance your first mortgage for a larger dollar amount than its current principal balance. using the equity built up in your home. The difference between the balance and the new loan is yours to use for any purpose.
- A cash-out loan is worth considering, if you can get a lower interest rate on the loan than your current mortgage.
- You will only have one monthly mortgage payment in a cash-out refi
HELOC, Second Mortgage, and Cash Out Refinance Cons
Most HELOCs come with an adjustable interest rate, so your interest rate will fluctuate throughout the term of the loan. Make sure to know how often your interest rate can change and what the caps are for interest rate changes at one time and for the life of the loan. Variable interest rates along with the changing balance on your HELOC, depending how you use it, lead to shifting monthly payment obligations. This makes it hard to predict what your monthly payment will be from month to month.
- HELOCs require spending discipline. You may be tempted to use the card or checks for purchases you do not need. Be sure tto use the loan for its intended purposes, if you go with a HELOC.
- Some HELOCs require balloon payments after a certain amount of time. This means that a large payment is due at a specified time. Know the terms of your loan, so you are not taken by surprise by a balloon payment. At some point in time, the HELOC requires that all of the outstanding balance is due. Make sure that you know how you will pay for the final payment on your HELOC. A HEL second mortgage or a cash-out refinance might be better for you, if you can't budget properly to cover the required large payment.
HELs, like HELOCs, will come with a higher interest rate compared to a cash-out refi. Lenders face higher default rates on second mortgages. Also, second mortgage loans sit in a junior position to the first mortgage. For these two reasons, HELs and HELOCs carry a greater risk for the lender, so the lender will charge you a higher interest rate.
- If you are not sure how much money you will need to borrow, a HEL is not likely a good fit. You start paying interest on the entire principal as soon as the loan closes. If you only plan to spend a portion of the proceeds in the near future, the flexibility of a HELOC will better suit your needs.
In a cash-out refinance, even with a lower interest rate, you may pay more in interest to your lender over time, because your loan term starts over once you accept the new loan. The further along you are in your first mortgage and the less interest you are paying each month, the less reason there is to refinance it.
- Any points you have to pay are based on the total loan balance. Because the balance in a cash-out refi includes not only the cash you want to take out, but the remaining principal balance on your current mortgage, you may pay higher fees.
Once you decide between a HELOC, HEL second mortgage, or cash out refinance, be sure that you check out a few lenders to compare what they offer. Read ALL the fine print on your contract, so you can avoid surprises. By taking the right steps to protect yourself and knowing what type of loan best suits your needs, you improve your chances of having the best possible loan experience.