As mortgage interest rates continue their rapid ascent in 2022, existing homeowners with fixed rate mortgage loans in the range of 2%-4% are holding on to those loans for dear life.
Truthfully, there would be no incentive for those homeowners to refinance their loans unless they needed any of the following:
- A better interest rate, and lower payment
- Convert an adjustable-rate loan into a fixed rate
- Tap into equity and pull cash out
With interest rates currently sitting around 6% for your standard 30-year fixed rate mortgage, it is unlikely that a borrower would refinance their mortgage unless they needed to tap into their equity.
Common reasons for a homeowner needing to cash-out some of their house equity include:
Credit cards, auto loans, and other debts usually have super high interest rates and/or burdensome monthly payments. Pulling cash out of your home can reduce your payment and save significant interest expenses.
Planning to renovate or upgrade your home? Cosmetic improvements, or a full remodel? House equity is a great way to access capital, while also reinvesting in your home for the long term.
To divide the house in a divorce, the spouse retaining the home is likely to have a buyout obligation (usually 50% of the house equity) as part of the final divorce settlement agreement.
The most familiar approach for a cash-out refinance is to secure a new 1st mortgage large enough to replace your existing one, with the excess proceeds delivered to you at closing.
For example, you have a current mortgage of $550,000, and you need $300,000 cash out. Therefore, you would apply for a new 1st mortgage of $850,000 – sufficient to pay off your current balance of $550k and put $300k in the bank.
However, if you refinanced in the past few years at historically low rates, you might prefer to keep that low-rate mortgage for as long as you can.
Your next best solution would be to secure a new 2nd mortgage. There are two types of 2nd mortgage options worth considering:
1. Pros and Cons: HELOC – Home Equity Line of Credit
- Revolving account which allows you to take draws on an as-needed basis
- Only pay interest on the amount of principal outstanding (the outstanding balance)
- Allows for interest-only payments, usually for the 1st 10 years
- No prepayment penalty for paying off the balance early
- The interest rate is variable on a monthly basis. Most HELOC’s are Prime (variable) + Margin (fixed)
- After the 1st 10 years, the loan converts from an interest-only loan to a fully amortized loan for the next 20 years (rate remains variable)
- After the 1st 10 years, no more draws can be taken from the line of credit, and any available credit is frozen
How to Calculate HELOC Payments
$100,000 HELOC fully withdrawn at 8% interest rate
Note: HELOC rates are variable and are usually subject to change monthly with movement in the Prime rate.
Year 1 – Year 10: Interest-Only Period – The monthly payment for a $100,000 HELOC at 8% would be $667.00 per month.
Year 10 – Year 30: Repayment Period – Loan converts to fully amortized payments. Assuming $100K balance at rate of 8%, new payment becomes $836/mo
2. Pros and Cons: HELOAN – Home Equity Loan
- They usually offer a fixed interest rate with fixed fully amortized monthly payments
- Since the interest-rate cannot increase, the resulting monthly payment also cannot increase
- Suitable for a larger one-time lump sum withdrawal when all proceeds are needed up-front
- Interest rate may be higher than a HELOC in exchange for the fixed rate aspect
- Does not allow for future withdrawals after loan closing
- No interest-only payment feature results in a higher payment requiring principal + interest
- May have a prepayment penalty for paying off the balance early
How to Calculate HELOAN Payments
HELOAN of $100,000 at 8% 30-Year fixed rate loan.
Standard payment calculation using a loan amount of $100,000, fully amortized at a rate of 8% (fixed for 30 years)
Year 1 – Year 30: Fully amortized repayment – $733.76/mo for entire term
HELOC’s and HELOAN’s will continue to grow in demand and popularity as interest rates and home equity remain at elevated levels.
Determining the right product for any particular borrower is highly circumstantial, so we encourage you to understand ALL of your options before attempting to make an informed decision.
The final decision will depend on your financial priorities, overall risk tolerance, and timeline for needing access to the funds.
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