Cash Out Refinance vs. Home Equity Line of Credit Explained
I. Cash-Out Refinance Loans
II. Home Equity Line of Credit Benefits
III. Debt Levels by Generations
IV. Paying Off Consumer Debts
V. Credit Scores and Borrowing Costs
Did you know that unpaid consumer debt has now reached all-time record highs while savings rates for Americans have reached all-time record lows? The old “cash is king” saying has a lot of truth to it. Yet, most people have their “cash” tied up as illiquid equity in their main home or in rental properties.
Do you want to pay interest payments on the entire loan amount or just on the amount of borrowed funds that you need at closing? It can be a significant monthly payment difference between these two loan options that can vary by hundreds or thousands of dollars per month.
Generally, a cash-out refinance loan is a primary loan in first lien position. Most often, a borrower applicant will pay off their existing first mortgage with a much larger cash-out refinance loan while paying off additional consumer debts and/or making improvements or upgrades to the home.
To simplify, a cash-out refinance loan in first or second lien position can be both helpful to your credit payoff and liquid cash needs and quite expensive at the same time. This is because your interest payments on the entire loan amount begin shortly after closing for the $100,000, $200,000, $300,000, or $500,000+ loan amount. Many times, the interest rate is fixed and the payments are equal in amounts over the loan term that may run anywhere from five to 30 years.
Prior to early 2022, many of these cash-out mortgage refinances increased the loan amount while reducing the mortgage rate at the same time. However, rates have rapidly increased starting in the second quarter of 2022 through present day. Now, the choices for consumers become a bit more complex because they may be locked in a mortgage rate somewhere near the 2.5% to 4% rate range. If so, borrowers aren’t as motivated to refinance into a cash-out first mortgage with a rate that is two or three times higher.
A big negative for choosing a cash-out first mortgage loan option is that you’re resetting your amortization schedule for payments. With a 30-year fixed rate mortgage, you’re primarily paying interest in the first seven years of the loan. After the seventh year, then you start really paying down the principal balance until it eventually reaches a zero balance by the 30th year or after the 360th monthly payment.
A homeowner who refinances their existing mortgage payment which they’ve held more than seven years will be going from effectively paying interest-only on a fully-amortizing (principal and interest) to restarting the clock with a new first mortgage while having to wait another seven years until they start paying down their principal balance.
Key point: The average homeowner stays in their same first mortgage for approximately seven years. After the seventh year, the homeowner may sell the property or refinance into a larger cash-out loan or select a rate-and-term refinance to lower the mortgage rate.
Here are some common mortgage underwriting requirements to qualify for a cash-out mortgage:
Steady income history: Underwriters like to see at least two solid years of consistent income by way of reviewing tax returns, W2s, or bank statement deposits in some of the more flexible loan products.
Sufficient amounts of equity: Many lenders don’t want to lend over 75% to 80% loan-to-value, so you may need 20% to 25% equity at the time of application. High credit scores: The better your FICO credit scores, the more likely that you’ll qualify for a new 1st or 2nd mortgage. Many lenders like to see credit scores in the high 600 to low 700 rate ranges.
Lower debt-to-income (DTI) ratios: A high number of lenders prefer to see borrower applicants with 43% DTI ratios. This means that an estimated 43% of the borrower’s monthly income is used to cover existing or proposed monthly debts related to things like mortgage payments, credit cards, car payments, and student loans.
If you want to accelerate the payoff of your principal balance on the first mortgage, it may be much wiser to keep it in place and pull cash out of a HELOC in second lien position.
A HELOC is a revolving line of credit that is secured by your home’s equity as the primary collateral. Home equity is the difference between the current market value of your home as determined by an appraisal report and any existing mortgage debt. For example, a home valued at $600,000 that had a $200,000 first mortgage on it would have $400,000 in home equity available ($600,000 - $200,000). Closing costs are likely to be much lower for a home equity line of credit than for a cash-out loan.
For most Americans, the bulk of their net worth comes from the equity in their main home where they live. However, it can be quite challenging to convert that equity in the primary home into spendable cash to pay off monthly credit card debt or skyrocketing utility bills. The closest option available for homeowners to create the equivalent of a new checkbook linked to the home equity is the HELOC solution.
The homeowner can borrow funds today and pay it back in full weeks or months later while maintaining a zero balance on the HELOC for most of the year. The flexibility of choosing loan balances as needed makes HELOC a far superior loan option in today’s higher rate world due to this likely cheaper option.
Now, let’s review the benefits of a home equity line of credit (HELOC) for borrowers:
The choice whether to select a cash-out first mortgage or a HELOC becomes much easier when rates are higher these days than back when mortgage rates were at or near all-time record lows. Some fortunate borrowers in years past were able to pull cash out of their loan and increase their principal loan balance while lowering their mortgage rate and monthly payments at the same time.
For example, let’s compare a homeowner’s loan selection choice from a year or so ago:
Existing mortgage balance: $300,000
Mortgage rate: 6%
Loan term: 30 years
Monthly payment: $1,798.65/mo.
If the same homeowner above wanted close to $100,000 out of a new cash-out mortgage to pay off high rate credit card balances and to remodel the interior of the home, then a cash-out loan at a much lower rate seemed more attractive.
Proposed new mortgage balance: $400,000
Proposed new mortgage rate: 3%
Loan term: 30 years
Monthly payment: $1,686.42/mo.
In this fictional example above, the homeowner increased his or her loan balance by $100,000 while dropping the monthly mortgage payments by $112.23 per month ($1,798.65 - $1,686.42).
In early 2023, this option to increase the loan balance and decrease the monthly rates and payments is becoming much more rare unless the borrower is paying off a high rate private money loan. In low rate environments, a cash-out refinance makes more sense for borrower applicants. However in higher rate worlds like today, a HELOC is usually much more beneficial to the borrower while you keep your low rate first mortgage in place.
To learn more, watch the Hitch digital HELOC video linked here: Hitch HELOC
Regardless of your age range, the bulk of your net worth or your parent’s net worth will likely originate from the equity in the primary home. While many younger investors are actively investing in stocks, new business startups, or cryptocurrencies that can widely fluctuate from very high valuation down to as low as zero dollars. Many of the wise cryptocurrency investor millionaires created even more wealth by rolling their cryptocurrency gains into the purchase of more real estate properties.
While equity gains in real estate can create incredible wealth for you and your family, debt from credit cards that’s compounding at 20%+ rates is equivalent to an anchor holding you back.
Let’s take a look next at some recent published data about credit card debt trends by age group as per a study conducted by New York Life:
In December 2022 when the New York Life study was completed, they defined Baby Boomers as people between the ages of 59 and 77; Gen Xers were 43 to 58 years of age; Millennials were seen as 27 to 42; and Gen Z were between the ages of 11 and 26.
By the end of the third quarter in 2022, unpaid credit card balances reached an all-time record high of $930 billion. This quarterly balance was $38 billion higher than the second quarter just a few months earlier and $121 billion higher than one year earlier. The 15% increase in year-over-year credit card debt between the third quarter of 2022 and the third quarter of 2021 was the highest annual percentage increase in more than 20 years.
The average credit card interest rate nationwide is now over 20%. An estimated 46% of all credit card holders carry their debt from month-to-month on at least one card. This is a jump from 39% one year prior.
By income levels, only about 45% of those people earning less than $50,000 annually were able to pay off their credit card debt in full. For people with $100,000 in annual income, approximately 63% of cardholders were able to pay off the debt, as per Bankrate.
If you keep rolling over just $5,000 in unpaid credit card debt which is compounding at 20% for a period of five years, the debt snowballs or balloons into $12,441 of bad debit five years later. The higher the interest rate on your credit card, the longer it will take to pay off the debt.
Next, we review the information about the HELOC funding solution that can help you pay off your debts sooner rather than later. Hitch has leveraged and combined advanced technology, the online loan application process, and access to capital for our clients so that it’s more simple and at a faster application and approval pace. To learn more details about the Hitch digital HELOC, see how much the equity in your home is worth here.
With access to liquid cash at all-time record lows these days, many people are living paycheck-to-paycheck while possibly spending more than 100% of their monthly income and borrowing from their 20% credit card balances to cover their bills.
Sadly, most people spend more than what they earn every single year. It’s so easy to waste money at the local coffee shop, restaurant, or bar when you could’ve stayed home and saved $25 to $200 each time.
To better visualize how relatively small amounts of money spent each day can magnify into very large amounts of debt or cash savings 12 months later, let’s take a look at what a daily expense of just $27.40 per day could’ve added up to as cash savings one year later:
$27.40 per day in expenses for 365 days = $10,001.00
If you were disciplined enough to reduce your daily spending by $27.40 per day for one year (365 days), then you’d have access to more than $10,000 one year later. If so, could you apply this $10,000 towards paying off credit card debt that’s growing by 20% per year? Or, could you take that $10,000 and apply it towards a down payment to purchase another property or to help another family member buy his or her first home?
What are some options to pay off credit card debt at a faster pace?
Build a monthly budget, reduce your monthly expenses, and stick closely to the new budget. Roll your high credit card rate balances over to other credit cards that may offer introductory 0% rates. Get a part-time job to increase your income. Apply for a HELOC to accelerate your consumer debt payoffs faster and to possibly increase the value of your home with improvements here.
The average American has a FICO credit score somewhere within the 690 score range. The FICO credit score ranges vary from a low of 300 up to a high of 850 which is essentially a perfect credit score rating. The three main credit bureaus are Experian, TransUnions, and Equifax. They collectively maintain credit files on upwards of 225 million consumers across the nation.
In 2023, there were two new credit score rating model systems that were introduced called FICO 10T and VantageScore 4.0. To simplify, these credit score models will now look at past rental payment and telecommunications or phone bill payment histories. Due to national tenant moratoriums related to Covid-19, many tenants across the nation haven’t made their monthly payments on time or possibly at all for months or years at a time. As a result, these credit score models may really hurt their future credit scores.
Specifically, these two new credit score models are being used by Fannie Mae and Freddie Mac, which are the two largest mortgage investors in the nation. As a result, these new scoring models will affect homeowners probably more than anyone else, for better or worse.
The higher your FICO credit score, the more affordable your future borrowing rates and fees. One of the main benefits with a HELOC is that it can consolidate two, three, five, or 10 lines of separate credit into just one new HELOC loan at a much lower rate. As a result, it may boost your FICO credit scores by 20, 30, 50, or 100 points.
You need to remain in control of your finances. You’re the person who can best protect you and your household more than anyone else. To get started on unlocking the value of your home, click here to get started: Home Equity Line of Credit
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