Property values over the past decade have really been on a roller coaster ride.
Around the middle of the last decade, lenders invented new home equity mortgage programs to try and reach as many potential borrowers as possible.
Doing so, they lowered acceptable credit scores, ignored any employment or income information and asked for less and less down payment. This new surge of home buyers pushed up property values all across the country and home ownership hit a new high around 2004. Soon though, lenders ran out of borrowers and those toxic loans that were made began to default. We all know the rest of the story but as lending tightened and those toxic loans and the lenders who made them vanished from the lending landscape property values began to fall.
Today, not only have property values recovered in most major metropolitan areas homeowner equity has also returned. For those that have owned and financed a home within the past 10 years have seen values fall and rise. And as lenders have returned to more common sense underwriting and being required to verify borrowers have a documented ability to repay a mortgage loan, not only have delinquencies fallen but borrowers have access to this equity. Borrowers can even set up a new home equity line of credit as a subordinate lien option when purchasing a home.
Getting to the Equity
Equity is the difference between what is owed on the property and the current market value. Market value is established using a property appraisal that researches recent sales of similar type properties in close proximity to the subject property.
A 3,000 square foot home that sold in San Ysidro wouldn’t be considered as a valid comparable sale if the subject property was located in Rancho Bernardo, for example. You can’t compare the price of condo to single family home, either. Appraisals need to list at least three similar properties in the subject property’s neighborhood or community. The closer the comparable sale, the better.
The most obvious way to turn that equity into cash is to sell. If a home is valued at $1 million and there is a $750,000 outstanding mortgage, if the home sold the cash proceeds to the owner would be $1 million – $750,000 – Closing Costs= Net to Seller. Any outstanding second liens must also be paid off at closing as well as any other superior liens such as property taxes or income taxes.
Cash Out Refinance
The next way to tap into that equity is pulling cash out during a refinance. There are two primary types of refinancing, a “rate and term” and a “cash out.” A rate and term refinance is performed when the borrowers decide to replace an existing loan with a new one and obtain a lower rate, to change the loan term or both at the same time. A cash out refinance can be used with any of these three choices but also puts some money in the borrower’s pocket. This money turns existing equity into cash.
As with any mortgage there are closing costs involved and unless the borrowers elected to accept a slightly higher interest rate in order to receive a lender credit used toward closing costs, the net proceeds to the borrowers will be reduced due to these additional costs.
Borrowers who refinance a loan can expect a similar round of closing costs they experienced when financing the purchase but this time around those fees might be even higher, considering a new title insurance policy needed. Borrowers can request a closing cost estimate from a loan officer over the phone for a cash out refinance to get a general idea of how much might be available.
Because of these additional fees however, a cash out refinance shouldn’t be taken out solely to access existing equity. The cost of those funds alone can offset the advantage of pulling out cash. However, if a rate and term refinance makes sense then pulling out cash during the process might be an option. A cash out refinance can have a slightly higher interest rate compared to a rate and term refinance so this option should be weighed carefully. Also, there may be a maximum loan-to-value requirement that limits how much the new cash out refinance amount may be compared to the current market value. For instance, a conventional loan may limit a cash out refinance to 80 percent of the property’s value. As well, an 80 percent loan to value amount might incur a higher rate or fee compared to a cash out refinance where the new loan balance would be 60 percent of current value. Because of these limits, borrowers aren’t able to tap into all or most of the equity when refinancing.
Home Equity Mortgage
The most convenient and lowest cost option to turn equity into cash is with a home equity line of credit, or HELOC.
There are several reasons and why you should consider taking advantage of a HELOC on your primary residence or apply for one to be used alongside a first mortgage when purchasing a home.
Avoiding Private Mortgage Insurance (PMI)
When you use a HELOC in conjunction when buying a home you can avoid PMI. Private mortgage insurance is a requirement for conventional loans when the loan balance is at or above 90% of the sales price of the home. When the buyers have 10% available for a down payment, they can choose to have mortgage insurance or a second lien. PMI rates today are much higher compared to secondary financing and is usually the option chosen by buyers. Your loan officer can run some numbers for you showing just that.
Yet employing a HELOC when buying a home offers two distinct advantages over either PMI or a fixed second purchase money loan. Taking out a HELOC and immediately using the funds to pay the first lien down to a conforming level, reducing the interest rate overall on the first mortgage. Second, because the HELOC is a revolving line of credit the funds from the HELOC can be used over and over again as the loan balance is paid down.
With PMI, the only way to remove the higher monthly payment is to have the property appraised when the first mortgage lien falls at or below 80% of the current value of the home. The value can be reached by paying down the mortgage, a natural increase in property values or a combination of both. This is an expensive proposal. When buyers use a purchase money second mortgage the principal balance falls as payments are made but the growing equity cannot be used again. And finally, using a HELOC keeps more of your own cash where it belongs- in your bank account.
A HELOC can go up to 100 percent of the current market value of the home. Using the example listed earlier, with a property valued at $1 million and an outstanding mortgage balance of $750,000, a HELOC can be opened up with a $250,000 credit line.
A HELOC operates in very much the same manner as a credit card. When a new credit card is issued it comes with a credit limit. Interest is only charged on the amount withdrawn and just like a credit card, the outstanding balance can be paid off completely with no penalty. The borrowers have the option of making a minimum monthly payment, more than the minimum or paying off the outstanding balance.
Interest rates for a home equity line of credit can be either fixed or adjustable, depending upon the combined loan to value of the first mortgage and the HELOC. Interest rates for a HELOC will be slightly higher than for a first mortgage as are all second liens but way lower than a personal loan from a bank or a credit card.
Because rates for a HELOC are so much lower compared to other types of borrowing it might make sense to consolidate some debt. If you have an automobile loan for example and the interest rate is say 5.00% a HELOC can be used to pay off that higher interest loan. Credit card debt especially might be a good idea as interest rates for unsecured debt are always higher than a HELOC. Paying off higher interest rate debt with a HELOC will lower your overall monthly payments. Note however, this strategy doesn’t work if the retired debt is replaced by new debt.
Interest Only Option
Different HELOC programs can offer an interest only option lowering the required monthly payment further still. Borrowers have the option of paying the minimum “fully indexed” rate or just the simple interest based upon the outstanding balance. Caution again however, as not paying anything toward the principal means higher borrowing costs because the principal balance never falls.
A Tax Benefit
It doesn’t make sense to take out a loan just because the interest is tax deductible but an added advantage of a HELOC compared to other forms of borrowing is the interest may be tax deductible. There are specific guidelines that you must follow and the loan cannot exceed $100,000 for a couple or $50,000 for an individual.
Still, you can’t deduct interest on a credit card or automobile loan. Speak with an income tax professional for specifics on income tax deductibility.
Your loan officer will provide you with all the specifics but it’s important to note these highlights:
- No Prepayment or Early Termination Charge
- Qualification Based Upon Primary Wage Earner
- Minimum Three Trade Lines on Credit Report (closed or open)
- No Tax Returns and No Transcripts Need if Not Self Employed
- Paying Off/Reducing Debt to Qualify OK
- Total Exposure to $1.5 million
- We Can Use Existing Appraisal if < 120 Days Old
- Competitive Rates and Terms
- Minimum Credit Score 720
- No Bankruptcy Within Past 8 Years
- No Foreclosure/Short Sale/Deed-in-lieu Past 5 Years
- Owner Occupied and Second Homes Only, No Investment Property
- Condo Eligible
- Maximum Loan Amount $350,000
It’s obvious the HELOC option is the least expensive and more flexible of the three ways to tap into equity. These are the basic guidelines you must follow to obtain a HELOC but they’re relatively easy to qualify for but there are others so you’ll need to speak with a loan officer.
If you’re refinancing to get a lower rate or say switching from an adjustable rate mortgage to a fixed rate loan, check into a cash out refinance. But if you want the lowest cost option as well as the simplest, the HELOC is the way to go.