by Broderick Perkins
Consumers enjoying increased equity in their home don't always make the best decision about how to tap their equity.
In a recent survey, during the first quarter of 2000, 79 percent of Freddie Mac-owned loans were refinanced with loans that were at least 5 percent larger than their original mortgage, compared to 57 percent during the first quarter of 1999. Among those who refinanced fixed-rate mortgages, they refinanced with loans that were a median 0.3 percent more expensive than their original loan, according to Freddie Mac.
Refinancing is down overall, due to higher interest rates, but home owners who did refinance did so to tap the median 27 percent increase in home equity during the first quarter this year, compared to 11 percent in the first quarter last year, Freddie Mac said.
How best to tap that equity demands a look at the options.
You have three basic choices.
Here's a look at some of the pros and cons your should consider for each type.
When you refinance your original mortgage, you swap it for another, often because the rate of the new mortgage is cheaper. If you refinance your existing mortgage, along with some or all of the equity, you can then take out the equity as cash to use as you wish.
Pros: If your original mortgage's interest rate is higher than prevailing rates or carries an adjustable interest rate that has been trending up, a cheaper fixed rate can cost you less each month -- even if you take out a little equity -- and you needn't worry about future increases in your monthly payment.
Also, if you made a low down payment on your original first mortgage and had to pay private mortgage insurance, the refinanced mortgage could rid you of that extra expense, provided your new loan is 80 percent or less than the value of your home.
Compared to your other two equity tapping choices, this choice comes with only one monthly payment.
Cons: Today's interest rates could be more expensive and that could cause a higher monthly bill, especially if you tap the equity. A refinanced mortgage is more application intensive than other options and the cost can include points (each point is one percent of the financed amount) other loan charges and escrow fees and time, nearly as much as your original loan.
Unless you cut the term to say to 15 or 20 years, a refinanced mortgage is like starting all over again with a 30-year mortgage.
If you choose an adjustable rate mortgage (ARM), to offset the possibility of higher payments, you'll have to prepare yourself for the inevitable adjustments upward.
If your want to borrow more than 80 percent of your home's value, the other options could be better choices.
Home equity loans
With a home equity loan you don't touch your original mortgage, but borrow cash against your equity.
Pros: The simplest and perhaps the most lucrative way to tap your equity, some second mortgages allow you to borrow money that will bring your total indebtedness on your home up to 125 percent or more of its value. You can pay back the lump sum in monthly installments, usually for a fixed rate, over a fixed term, usually from 10 to 20 years.
Cons: Home equity loans rates can be one to several points more expense than interest rates on a refinanced mortgage.
If you borrow more than your home is worth, you may not be able to afford the payments and you won't have any more equity to tap should an emergency arise.
You may not be able to deduct all the interest. Joint tax filers mortgage interest deduction is limited to the lesser of a $100,000 maximum and the home's fair market value determined by a complicated formula in IRS Publication 936 ''Home Mortgage Interest Deduction.''
Beware of second mortgages with blimp-sized balloon payments and prepayment penalties.
If you're borrowing cash to pay for your kids' education some time in the future, or for a long-term remodeling project, this loan probably isn't for you. You'll be making payments right away for money you haven't spent.
Home equity lines of credit
"HELOC" for short, home equity lines of credit begin with a quick approval, few if any up-front costs and the lender handing you a checkbook, credit card or some other method to access to your equity money. Working much like a credit card, you dip into the till only when necessary.
Pros: You don't get dinged for interest until you actually use your cash. That's a handy financial tool to have, say, for a home improvement project you pay in installments.
You generally won't be saddled with a large prepayment penalty if you only need the money for a short time.
Low introductory variable rates let you use money for less than if you opted for a fixed-rate home equity loan. Other flexible features can be built into your HELOC. For instance, if you pay off your balance, your line of credit can remain available for the life of the line of credit.
Cons: Lines of credit can get expensive. HELOCs are almost always adjustable rate loans with periodic interest rates charges continually applied to your loan balance, much like a credit card.
While the rates are much less than most credit cards, they do "feel" like a credit card and temptation could cause you to use it much like you use your plastic -- for every day shopping.
Each withdrawal could come with a fee and if you reach your limit, you could be short should a real emergency arise or it comes time to pay for a big-ticket item.
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