U.S. homeowners have a record amount of equity they can tap into, but tax laws may change the way they access that money. In the past, HELOCs have made the most financial sense, but tax experts say the best option now could be a cash out refinance, even if it means a small increase in the property owner’s primary mortgage rate.
Black Knight’s “Mortgage Monitor” reported, its annual index for home appreciation rose more than 30 basis points for the three months that ended last November, and more than 80 basis points from the beginning of last year. That’s reduced the number of underwater mortgages by 37%, or about 800,000 loans, since January, 2017 (1).
New Low for Underwater Homes
The number of “underwater” homes is still higher than it was before the housing crisis, but has now dropped to just 2.7% of all mortgages, or 1.26 million households. That’s the lowest since 2006, and a huge improvement from 2011, in the wake of the recession, when 11.6 million households were underwater, according to data from CoreLogic.
Of the households that are now in positive territory, Black Knight said, 42-million of them qualify for home equity loans because they have loan-to-value ratios that are below 80%. The total amount of equity available to those 42-million homeowners is now almost $5.4 trillion. That’s $3 trillion more than they had in 2012, because of rising home prices.
With more than half of those homeowners enjoying interest rates below 4% for primary mortgages, a home equity loan, or a home equity line of credit or HELOC might seem like the best method for getting hold of that equity. But, as Black Knight reported, new tax rules could make that option more expensive than it’s been in the past.
HELOC Interest No Longer Deductible
Black Knight’s Ben Graboske said, “With the recently passed tax reform package, interest on these lines of credit will no longer be deductible, which increases the post-tax expense of HELOCs for those who itemize.” Graboske said, home equity borrowers may find that a cash-out refinance is a better option.
He said, “In many cases, for those with high unpaid principal balances who are taking out lower line amounts, the math still favors HELOCs.” For low-to-moderate UPB borrowers taking out larger amounts of equity, he said, “The post-tax math for those who will still itemize under the increased standard deduction may not favor cash-out refinances instead, even if the result is a slight increase to first-lien interest rates.”
He also said, the cost benefits could swing back and forth between the two options, depending on interest rate increases that could make refinancing more expensive, and HELOCs more attractive even without the deduction. Overall, he said, the tax take-away will probably have an impact on HELOC loan amounts and lending volume as well as the cash-out option. But, he continued, “It still remains to be seen whether and to what extent tax costs will impact borrower decisions.” (2)
Tapping Your Equity Reserve
Homeowners with a lot of equity shouldn’t be discouraged by the tax law changes. They should do their own cost analysis that includes the costs of tapping into their home equity, along with the benefits of a potential property acquisition.
Remember, there are three ways to get hold of the equity in your home.
A HELOC is the most flexible of the three. The borrower opens a line of credit and can withdraw money as needed, up to a certain amount. Most also come with their own checkbook or debit card for easy access to that money. According to Investopedia, there are typically no closing costs for a HELOC, and borrowers can usually pay just the interest on the loan each month. The total amount would be due at the end of the term (3).
A Home-Equity Loan, or second mortgage, is also an option. The loan structure is similar to a principal mortgage, except that the interest rate is usually higher. The loan-to-value ratio requirements may also be higher.
The third option is a Cash-Out Refinance. In this scenario, the homeowner refinances the principal mortgage as a larger amount, and takes the difference in cash. Investopedia warns that the closing costs can be expensive.
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(2) HELOC vs Cash Out Refinance: National Mortgage News