As a homeowner, you make mortgage payments to pay off a debt you took on to purchase your home. From a strictly financial standpoint, you’re placing money into an asset -- your home -- that you can leverage in the future. If you need money for a large purchase or to help pay down other debt, the equity in your home can be liquidated through a new mortgage or a home equity loan.
Home Equity 101
When you’re paying off a mortgage, home ownership isn’t the same black-or-white transaction as when you purchase a good from a store. Each payment you make to your lender partially covers loan interest charges and partially pays down your principal. For each dollar you pay toward your principal, you gain a dollar’s worth of ownership in your home. This concept, known as equity, means that you own a portion of your home long before you pay off your mortgage, and you can use that equity in different ways.
In a cash-out refinance, which is sometimes known as a remortgage, you take out a new mortgage based on your home’s present value. If your existing mortgage balance is less than the home’s new value, you receive the difference -- your equity -- in cash at closing. Your new mortgage replaces your old one, you lose all the equity in your home and you begin paying interest on the full loan balance. You’ll also need to cover closing costs and other costs required by your lender, such as mortgage insurance. These costs can eat into the total amount you pull out.
Home Equity Line of Credit
A home equity line of credit, or HELOC, keeps your primary mortgage in place and functions as a second loan against your home. HELOCs use the equity in your home as collateral. It functions as a line of credit, like the line of credit extended by a credit card, rather than providing a lump sum loan. You only pay interest on the amount of credit you use at any given point. You don’t need to pay closing costs or any other charges, and because you only pay interest on funds that have been advanced to you, a HELOC is more flexible than a cash-out mortgage. The down side? Because lenders are second in line behind your mortgage holders if you default, HELOCs typically have higher interest rates to compensate for their added risk.
Weigh Your Options
Determining if a remortgage or a HELOC is right for you depends on your circumstances. If you seek a short-term loan, a HELOC may be your best choice, as it offers the shorter payback, or amortization, period, and lenders typically provide the lowest rates to short-term loans. If you need to leverage your equity to pay a large bill, a cash-out mortgage may be your best solution, as a 30-year amortization schedule may be the only way to keep your monthly payments low enough to keep you within your budget.
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