Welcome to NerdWallet’s Smart Money podcast, where we answer your real-world money questions.
This week’s episode starts with a discussion of why you probably want to file your taxes sooner rather than later.
Then, we pivot to this week’s question from B, who writes, “I have a fixed 30-year mortgage at 3%. With 22 years left to go, I can save $300 to $400 a month with a refi at 2.75%. That's a 30-year fixed with a local credit union and no points. We plan on staying in the home for at least the next seven years and may want to use the extra cash from the refi to put down on a second home, or does it make more sense to use our HELOC as a tool for down payment?”
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Tapping your home equity — through a loan, line of credit or cash-out refinance — involves some risk. You could lose your home to foreclosure if you can’t make the payments, which is why financial planners generally discourage tapping your home equity for uses that don’t build wealth, such as vacations, cars or paying off credit card debt. But using some equity to fund the purchase of another home can make sense, since that home can grow in value.
The best way to tap your home equity depends on a number of factors, including how long you’ll need to pay back the money and the interest rates on each option.
For example, B could opt for a cash-out refinance that replaces their current mortgage with a larger one, giving B the difference in cash to use as a down payment. Primary mortgages tend to have the lowest interest rates, but B is committing to a long payback period and easily could pay more in interest overall compared with the other options.
Alternately, B could take out a second mortgage in the form of a home equity loan or home equity line of credit. Home equity loans typically have higher interest rates than primary mortgages, but also come with fixed rates and relatively long terms, usually 15 to 20 years.
By contrast, a home equity line of credit is more like a credit card. Rates are typically variable, and paying down the balance generally frees up credit that B could reuse. Many HELOCs also offer the option to fix the rate on a portion of the balance for a year or more. HELOCs usually have a 10-year draw period with interest-only payments. After that, payments get significantly higher as you pay principal and interest.
HELOCs are often a good choice for short-term borrowing, such as for home repairs. But a cash-out refinance would give B the chance to lower the rate on their primary mortgage while providing relatively cheap cash for the down payment money. A home equity loan might be a good compromise if the homeowner didn’t want to refinance their primary mortgage but wanted a fixed rate and more time to pay back the loan.
Understand the risks. You could lose your home to foreclosure if you can’t pay back a home equity loan or line of credit.
Weigh your options. HELOCs are good for short-term borrowing. A cash-out refinance or home equity loan might be better for longer-term use.
Shop around. Compare different offers and apply to at least two lenders to get the best deal.
Liz Weston: Welcome to the NerdWallet Smart Money Podcast, where we answer your personal finance questions and help you feel a little smarter about what you do with your money. I'm Liz Weston.
Sean Pyles: And I'm Sean Pyles. If you want your money questions answered on a future episode, turn to the Nerds, call or text us your questions on the nerd hotline at 901-730-6373. That's 901-730-NERD, or email us at firstname.lastname@example.org.
Liz: And hit that subscribe button to get new episodes delivered to your devices every Monday. If you like what you hear, please leave us a review.
Sean: This episode we're answering a listener's question about how and when to use your home's equity. First though, in our "This Week in Your Money" segment, Liz and I are going to give you three reasons why now, like right now, or maybe even tonight, is a great time for you to file your taxes and why you should do so electronically.
Sean: The first reason that I want to get out of the way is that filing your taxes early helps you get your refund as soon as possible. And this is really where filing electronically is super handy. It can take around one to three weeks for you to get your refund if you file electronically and use direct deposit, and this is compared to around six to eight weeks for those who file their taxes the old-fashioned snail mail route — if anyone still does it that way.
Liz: Well, a lot of people did, and they found out why you shouldn't do that with the pandemic because with the IRS shutting down, they're actually still going through those paper returns. They have not processed all the returns from last year. If you needed any encouragement to file electronically, that should do it. Just picture your refund hung up for months because that's what happens.
Sean: I actually filed before February 12, the first day that you technically could have your taxes accepted by the IRS because the online service that I typically use opened it up beforehand. And the very first day that the IRS was accepting taxes, mine was accepted. So I know that my refund is going to be in my bank account within the next couple of weeks, so I am very happy about that.
Liz: That's nice that they allowed you to do that. But we usually tell people to file early also because it's a good way to prevent tax refund theft. And if you haven't heard about this, basically the bad guys gin up a bunch of phony W2s and they make it look like you have this massive refund and they steal it. And that means that when you file, your return gets rejected. So filing early can help beat them to the punch. And also it's important to note that the IRS will now give you a personal identification number, even if you have not yet been an ID theft victim. In the past, you had to wait to be victimized to get one of these PINs. Now, you can just apply for it. It's not a particularly easy process, but if you're concerned about identity theft or tax refund theft, it's a good thing to do.
Sean: It's always nice to have a little bit more insurance to protect yourself, especially when it comes to something as sensitive as filing your taxes.
Liz: Yes, exactly.
Sean: Well, the last reason that I want to highlight for why filing your taxes early is a great idea is that it can actually save you money. Right off the bat, of course, filing on time can help you avoid penalties from filing late. The IRS can hit you with a late-filing penalty of 5% of the amount owed for each month or partial month that your return is late, so you always want to avoid that. But one that I didn't know about until recently is that the prices for tax professionals and software often rise starting in mid-March. If you're going to hire a professional or use one of those online services, be aware that what you're paying right now is less than what they'll charge you in the month leading up to the tax deadline.
Liz: And you should note that you may not have to pay to get your taxes prepared at all because the IRS has a program called IRS Free File, where they provide access to free tax-filing software from 10 different companies, so consider that. There has been a problem with some of these companies promising to do it for free and then charging you, so make sure if you meet the criteria that you are getting actual free filing. Your adjusted gross income has to be less than $72,000 to qualify, but the IRS estimates that 70% of all taxpayers are eligible for this service.
Sean: That's a great bit of advice because so many people have actually been duped into paying for these services when they didn't have to at all. And on our website, we have a good roundup of free tax-filing services, so we will make sure to link to that in our show notes for you.
Well, one last thing I want to note is that taxes this year are going to be more complicated than usual for many due to the unemployment benefits they received in 2020. And we're doing an episode in a few weeks about how the pandemic is affecting people's taxes this year. But in the meantime, send us your questions about the 2021 tax season. As always, you can call the nerd hotline at 901-730-6373, or email us at email@example.com.
Liz: Now let's get to a new segment that we're calling the "Best-of Minute," where we talk with the Nerds behind our Best-of Awards. We're talking once again with credit cards Nerd, Sara Rathner, about what makes the best credit card. Hey Sara, welcome back to the show.
Sara Rathner: Thanks Liz, always a pleasure.
Liz: Now, I'm sure you've gotten this question as well. Your friends will come up to you and say, what's the best credit card? Has that happened?
Sara: The moment somebody finds out that I work at NerdWallet, that is the first question. And my answer always disappoints them because my answer is always "well, that depends." And they don't like that because they were kinda hoping I would tell them what to apply for. But it does depend on so many different factors in your life.
Liz: But that's what the Best-of Awards are meant to do. There isn't one best card, but there are best cards for certain circumstances. What factors does the team consider when they're evaluating cards?
Sara: We look at a number of factors. We really look at every card from so many different angles. One big thing is the cost of carrying the card, annual fees, other fees like foreign transaction fees, late payment fees. The APR or interest rate is also a factor if you carry a balance on a card. We also look at any rewards programs a card offers because the monetary value of those programs can help offset an expensive annual fee, so it might make a card that charges an annual fee worth it for you. So we look at whether or not the card earns a sign-up bonus, or what ongoing cash back or travel rewards you can earn. And also how easy is it to redeem those rewards later on, because if that's really complicated, that's definitely not going to work in a card holder's favor. We really look at these cards holistically.
Liz: So obviously a lot of things have changed in the past year. How did our evaluations change?
Sara: The way that we spend money changed so dramatically and so quickly in 2020. And that means that some of the categories that we had in prior years simply didn't feel relevant anymore. We had a number of categories that changed or adjusted a bit. We had a category before that was best card for dining and entertainment. Entertainment expenses typically mean things like concert tickets, sporting events, movie theaters, all these things that we're not going to for the time being, unfortunately.
Now, we have a category that is best card for dining out and ordering in, so really the go-to entertainment right now is getting takeout for the most part. We also used to have a category that was best card for families. We've changed that to the best card for groceries. Best card for families is not very inclusive, but everyone needs to eat, and everyone's buying groceries right now. And so we wanted to really make the category inclusive of a number of different types of households.
As for categories that are on hiatus for the time being: premium consumer and business travel cards right now. Not as popular. It's just so hard to justify a credit card that charges a $500 annual fee. And normally you offset that fee with free checked bags and access to high-end airport lounges and all these other travel-related benefits that are irrelevant if you haven't been inside an airport in a year. Also, there's not a ton of cards out there right now for consumers with fair credit. There's just a really limited list of cards out there that have desirable terms like low fees, low interest rates, but there is an emerging market of what we call alternative credit cards. They use nontraditional underwriting methods to evaluate applications. They rely not as much on your credit score as they do maybe on your income or your bank account or other factors. And those are some pretty compelling options for people who are building their credit. One brand new category — I think this will appeal to everyone who has stopped wearing jeans — best cards for staying at home.
Liz: Oh, I love that.
Sara: And I'm wearing leggings right now, so I'm really feeling this category in my soul.
Liz: What are the criteria for that one?
Sara: This really had to do with cards that made it easy to buy things online.
Liz: Oh, OK.
Sara: There are cards out there that earn a higher cash-back rate that will give you an extended amount of time to return your purchases, things like that. They really do make it easier and more rewarding to shop online.
Liz: That's terrific. It's great to know that while all of us were pivoting, so were our criteria for judging credit cards. So bottom line, what does it take to be the best card?
Sara: It's about substance over style. Sometimes the best card for you is not the one that's trendy and exciting and has incredible marketing. It's this workhorse credit card that consistently earns rewards where you spend the most money.
Liz: Well, that sounds good. Sara, thank you so much for taking the time to talk with us about this.
Sara: Thank you for having me.
Liz: Let's get to this episode's money question, which comes from B. They ask, I have a fixed 30-year mortgage at 3% with 22 years left to go. I can save $300 to $400 a month with a refi at 2.75%. That's a 30-year fixed with a local credit union and no points. We plan on staying in the home for at least the next seven years and may want to use the extra cash from the refi to put down on a second home, or does it make more sense to use our HELOC as a tool for the down payment?
Sean: Very interesting question, B. With many words that I had to look up before, but to help us answer B's question on this episode of the pod, we are talking once again with home buying Nerd, Holden Lewis.
Liz: Hey, Holden, welcome back to the show.
Holden Lewis: Hey, thank you so much for having me on again.
Sean: Well, our listener has a pretty technical question, so I'm glad that you are here to answer it. Our listener is hoping to tap their home equity to fund a down payment on a house and has a couple of ideas about how to do it. First, let's talk about whether tapping home equity is a good idea in the first place. Can you talk about the pros and cons of this?
Holden: Let's talk about the main con. When you tap your home equity for any purpose. You're borrowing against your home's value, so you are actually putting your home at risk of foreclosure if you end up not paying that loan. That's a really big risk when you compare it to say, credit card debt or something like that, so that's the main con. The pros, well, they tend to be, you can get a pretty good interest rate on home equity lines of credit and mortgages and well, really, that's the main advantage.
Liz: I think, Holden, a lot of people aren't familiar with some of the terms that we've been talking about, so could you walk through the difference between a cash-out refinance, a regular refinance and using a home equity line of credit or a loan?
Holden: I'd love to. All right, so a regular refinance happens when you get another mortgage to replace your current mortgage and it's for the amount that you currently owe. Let's say you borrowed $250,000 a few years ago, you owe $200,000 now because you've paid $50,000 off of it. When you refinance, you would refinance for $200,000.
Now, with a cash-out refinance, you borrow more than you owe. So, in the situation I was talking about, maybe you borrow $220,000 and then you get that extra money as cash to use however you want to. It could be to pay off credit card debt. It could be a down payment on a second home, or it could be to fix up your home.
And then there's also a home equity line of credit, which is a credit line where you're borrowing against the equity in your home and you can borrow against it, repay it, borrow against it again like a credit card. And then home equity loan is another mortgage on your house that you pay in equal payments over a predetermined time, often 15 years.
Sean: Can you break out when one of these options might be better than another for something like a down payment on a house?
Holden: First of all, I want B to be assured that what B wants to do is something that people do. He's not going to be, or she, is not going to be laughed out of the bank when they explain that they want to borrow from their primary home's equity to make a down payment on a second home.
Sean: I have to go deeper into that a little bit because when I first read this question, the idea of tapping one house's equity to put toward a down payment on another house seemed really risky and raised a red flag. Maybe because I was in high school in the middle of the housing crisis and things were pretty scary, and I saw the risk of people that lost their houses and they did similar things. You're saying that it's actually not unreasonable to do something like this?
Holden: I don't think it's unreasonable to raise your down payment this way. And mostly the reason I say that is that a lot of people do it. Yeah, people did that during the housing bubble, too. I had a neighbor who bought a Harley and a Volkswagen Tiguan and he made a down payment on his girlfriend's house. This is a married man. He used money from cash-out refis. And I don't think people are acting irresponsibly nowadays, and we're not in a housing bubble. Even though home prices are going way up, we're not in a housing bubble. We're just in a situation where the demand exceeds the supply of homes that are available for sale.
Liz: And Holden, the banks were actually aiding and abetting the bad behavior before because you could actually borrow more than your home was worth, so a lot of people were doing that, too.
Holden: The lenders were so irresponsible and after the bust, there was a lot of finger-pointing at borrowers for being irresponsible. But the thing is, the bank knows more than you do about finance and about risk. And it was really the responsibility of banks to make correct decisions and they did not back then. Things are a lot more sane now, I guess you could say. Lenders are just much more responsible with their decisions now.
Liz: I think during that period people got into the habit of thinking that their equity should be working for them. It shouldn't just sit there, it should be out making them money. And in reality, your home equity can be an incredible resource that you really don't want to squander. It can help you in an emergency. It can also be something you can tap in retirement. And if you are continually borrowing against it or continually refi-ing it, you're going to go into retirement with a mortgage and you won't be able to access that money, even if you need it. So, to me, home equity isn't exactly sacred, but I would be very, very, very, very careful about tapping it. How do you feel about your home equity, Holden? Is it sacrosanct or is it something that you're OK with going into?
Holden: I'm OK with using my home equity to fix up the house. We had a home equity line of credit during the buildup, I guess you could say, from 2000 to 2007, and we're in Florida. And when the crash came, we owed, I don't know, a few thousand dollars on the HELOC and the bank just swooped in and said, all right, we are cutting your credit line to the amount that you currently owe. So we quickly just paid it off. It really made my wife mad. She actually walked into the bank to personally write a check and shove it in the loan officer's face.
Liz: Good for her. But that's a really good point that when you do have a line of credit of any kind, you're at the mercy of the lender. They can decide at any point to cut it off, to freeze it, to do what they did to you, which is lower the limit. So that's another thing to keep in mind. So if this is money, that again, you're going to be using for the long term, it might be better to get a loan and fix the rate.
Holden: The benefit of raising a down payment through a cash-out refinance is that you'll pay a lower interest rate on that refi because home equity lines of credit and home equity loans have higher rates than mortgages do. Let's look at HELOC rates. Lately, they've been averaging over 4%. B can get a mortgage at 2.75%, so that's definitely an advantage there. The drawback to a cash-out refinance is that you're putting yourself on the hook to pay off that down payment debt for 30 years.
Holden: Let's say you take out $30,000 cash when you get a cash-out refi. If you borrow that a 2.75% over 30 years, it's going to cost you more than $14,000 interest over the life of the loan. And the benefit to taking out a line of credit or a home equity loan is that you treat that debt separately, and you pay it off more quickly. And even at a higher interest rate, you'll pay less interest over time that way. And you can have a much higher interest rate on a loan for 10 years than on loan for 30 years, and you're still going to pay a lot less interest because you're just simply making a lot fewer payments.
Liz: Oh, that's a really good point.
Sean: I have a question about the amount for a down payment. Do you think it would be better if someone is going to go this route to stick to a smaller, maybe 3% down payment? Or is it that because they're taking out this loan anyway, they might as well go for a larger down payment?
Holden: The less cash they take out of their primary home's equity, the less risk they're taking with their primary home. In other words, you probably care more about being foreclosed on on your primary home than your second home. It might make more sense to make a small down payment on that second home and by doing so not take out as much cash out of your primary home's equity. You can get an FHA loan on a second home, and you cannot get a VA loan on a second home. But yeah, you can get a loan for a second home with a down payment of less than 20%.
Liz: So what you're saying is sometimes it's worth paying private mortgage insurance, which you have to do when the down payment is smaller, just to make sure that you're not overburdening your primary homes. Is that what you mean?
Holden: That's what I mean. And this person is going to be able to refinance at a lower interest rate on that primary home. And if it's just a straight refinance, they're going to save money every month.
Liz: Holden, we've been talking about one specific purpose, which is using the money to make a down payment on a second home. What about other uses of home equity? Now that it's easier, again, to get cash-out refinances, does it make sense to pay off credit card debt? Does it make sense to take it and buy a Harley? How do you evaluate what's worth tapping your home equity for?
Holden: This is a value judgment, I think, in a lot of ways, and it just makes my skin crawl to use home equity for purposes other than fixing up a home or making a down payment on another home, or maybe for tuition and fees. Those are things that are investments. You spend that money and you get more out of it, you hope. Other uses for money like vacations or cars, they're just depreciating assets and I'd be really reluctant to borrow from my home equity to pay for those things.
Sean: But Holden, memories are priceless. I want to fly me a trip around the world on my home equity. Just kidding.
Holden: Well, just ask me in 10 years because my goal is to hike the Appalachian Trail. And maybe in 2030, I'll be saying, hmm, maybe I should tap my home's equity.
Liz: Are there special risks that come with getting a home equity line of credit?
Holden: Yes. A home equity line of credit has a variable rate. It's tied to the federal funds rate, which is essentially 0% right now. That means there's nowhere to go but up. If you have a HELOC long enough, the interest rate is going to rise, and so will your minimum monthly payments. And don't forget, a HELOC is a loan with your home as collateral, so if you stop making payments, you could lose the house.
Liz: And something else people often aren't aware of is that the first few years of a HELOC, I think up to 10 years, is called the draw period, and you might be paying only interest, which means that when it's time to actually start paying down the principal, your payments jump quite a bit.
Holden: It's so interesting the way they're structured. During the draw period your minimum monthly payment is only the interest. You can pay the principal too, but your minimum payment is just going to be the interest. And that can possibly lull you into borrowing more than you can ultimately afford to pay. But there's one really great advantage, and that is you don't have to borrow the money all at once. When we were talking about tuition and fees, if you are paying tuition with a HELOC, you can borrow every semester. You don't have to borrow one lump sum amount and then pay your tuition and fees for multiple years after that.
Liz: If it's something that you are essentially financing for a long term, like a down payment, that's not something that you plan to pay back quickly. I think there's an advantage to getting a fixed rate, getting a fixed payment and paying it off over time. But if you are going to use it for a short period and pay it back, then it sounds like a HELOC makes more sense.
Holden: HELOCs have all sorts of interesting features. Most lenders, they will let you set aside a portion of the HELOC and fix the interest rate on it and then pay it off over a predetermined period. So, that's something that you could do. You could get a HELOC, pay a down payment with it and then say, all right, this $30,000, I want to set it aside and I want to pay it off at X interest rate over 10 years. And then you have a fixed rate and you have that fixed period and you know exactly what your payments are going to be for the next 120 payments. Boom, simple.
Liz: One thing we should point out is that if you take home equity to pay off something like credit card debt, you're taking something that could be erased in bankruptcy, which is credit card debt, and replacing it with debt that cannot be erased in bankruptcy, that's going to pretty much stay with the house. You want to be very, very careful about using home equity for that particular purpose.
Sean: Holden, you mentioned maybe using this for something like tuition or fees and this has been top of mind for me lately because my partner, Garrett, is thinking about applying to a grad program and he was tossing around maybe doing a cash-out refi for something like that. Can you discuss when that might or might not be a good idea?
Holden: I think a lot of it comes down to the interest rate that's available. With a cash-out refinance it may or may not have an interest rate that's lower than you can get on a student loan. I am not knowledgeable about taxes and what is adjustable and what's not.
Sean: Liz, I feel like you might be knowledgeable about this. What do you think?
Liz: I have a couple of reservations about that. One, we should mention that if you use home equity for anything other than buying or fixing up a house, it's not going to be tax deductible. It used to be in the past, but no longer is, so that's something to keep in mind. And with education in particular, if you have the option of borrowing with federal student loans, that's typically the way to go because those are very consumer-friendly loans. You run into a bad patch, you can get forbearance, deferral, pause payments for a while, there's income-based payment options. You don't have that with a mortgage typically, so those are two ways to point towards federal student loans.
Liz: And if Garrett's going to graduate school, he can borrow up to 100% of the cost. I think where people look at loans for tuition and fees is when they have an undergraduate, when they have a kid that they're trying to send through college. And most colleges don't give you enough financial aid, so the parents are trying to come up with money somewhere. They could do Plus loans, parent loans as well, but some people would just rather tap the mortgage for that.
Sean: All right. Well, another question for you, Holden, shifting gears a little bit. Are there any general guidelines for how long someone should stay in a home to recoup the costs of a refi?
Holden: The answer to that depends on the fees you'll pay and how much you're reducing the interest rate. But a rule of thumb is that it might take at least a couple of years, but that's if you're refinancing for the amount that you currently owe now. Let's say you're doing a cash-out refinance. Well, when you do that your primary objective is to borrow more money. It's not to save money. The time it takes to recoup your closing costs is irrelevant with a cash out refi. What's more important is looking at your options and figuring out which makes sense financially, whether that's a cash-out refinance, a home equity line of credit, a home equity loan or some other source such as borrowing against your retirement. I can just tell Liz's hackles are raising right now.
Liz: You can hear that? All the way in Florida you could hear that?
Liz: But no, that's a very good point. You do want to consider all your options. You don't want to lock in on just one and decide that's the way to go. And even then, you probably should be shopping around, right, Holden? Taking a look at what different lenders have to offer.
Holden: You should definitely shop around because if you go to three or five mortgage lenders and apply, one of them is going to have the best deal. It's going to be something when you look at the paperwork that you get, you're going to say, oh yeah, this clearly is the best one in terms of rate and fees. It really, really does pay to comparison shop.
Sean: It also gives you a certain amount of leverage. When I was shopping around for mortgages last fall, I applied for five, and I was able to say to one lender, look, this other company is just about neck and neck with you, but their fees are slightly better. But I wanted to go with a specific one because we had a relationship with them previously, and they were able to cut my fees by $900 because I had the paperwork showing this other company is slightly better than you, how can you match me? So that's a really big advantage as well, shopping around.
Holden: Definitely. And that was a case where you had a relationship with that lender. You probably knew that they had good customer service and that means something when it comes to your mortgage.
Sean: All right. Well, Holden, do you have any final notes for B?
Holden: Well, let's talk about a credit union because B is talking about borrowing from a credit union, and there's just not going to be any differences or many when applying. A credit union is going to want the same information. They might be a little more flexible in the underwriting. If the credit union plans to keep the loan on its books. For example, they might just be a little bit more forgiving about debt-to-income ratios. And if the credit union offers a lower interest rate, lower closing costs or both, then it's a winner. But I still suggest shopping. Even if the credit union is offering what looks like a pretty good deal right now, because there might be a competitor out there who offers an even better one.
Sean: All right. Well, thank you so much for talking with us, Holden.
Holden: You're welcome.
Sean: And now let's get onto our takeaway tips, and I can kick us off. First up, understand the risks. Falling behind on payments of a home equity product could put you at greater risk for foreclosure.
Liz: Next, weigh your options when considering a HELOC, a cash-out refinance or a home equity loan. Think about which one will help you meet your goals.
Sean: Lastly, shop around. Apply to at least two lenders, maybe even five, when shopping around for a product that allows you to tap your home's equity.
Liz: All right. And that's all we have for this episode. Do you have a money question of your own? Turn to the Nerds and call or text us your questions at 901-730-6373 that's 901-730-NERD. You can also email us at firstname.lastname@example.org. Also visit nerdwallet.com/podcast for more info on this episode, and remember to subscribe, rate and review us wherever you're getting this podcast.
Sean: And here is our brief disclaimer, thoughtfully crafted by NerdWallet's legal team. Your questions are answered by knowledgeable and talented finance writers, but we are not financial or investment advisors. This Nerdy info is provided for general educational and entertainment purposes, and may not apply to your specific circumstances.
Liz: And with that said, until next time, turn to the Nerds.