When you need cash for home improvements, school tuition, a down payment for a 2nd home, or debt consolidation, you might want to consider tapping into what could be your greatest source of wealth — your home equity.
Interestingly, there is more than one way to access your home equity – so it’s smart to compare available options to find the right fit.
Two of the most popular ways are a home equity line of credit (HELOC) and a cash-out refinance. Both of these loans can work if you want to access your home equity, but they do work rather differently.
The “Cash-Out” Refinance
Cash-out refinancing involves replacing your current home loan with a new one. The “cashing out” part of the equation means you essentially take out a larger home loan than you currently have so you can receive the difference as a lump sum. This strategy works for those who have equity in their homes due to paying down their mortgage balances or appreciation of their property.
To qualify for a cash-out refinance, you need to meet similar requirements as you would if you were applying for a first mortgage – and you must have the equity in your home to qualify, as well. You can borrow up to 80% of your home’s value.
So, let’s assume your home has a value of $300,000 and you want to take cash out. In that case, you could only borrow up to $240,000 through a cash-out refinance. If you owe that much or more on your home already, you wouldn’t qualify.
The Home Equity Line of Credit (HELOC)
While a cash-out refinance requires you to replace your current mortgage with a new one, a HELOC lets you keep your first mortgage exactly how it is.
Acting as a second mortgage, a HELOC lets you borrow against your home equity via a line of credit. This strategy allows you to withdraw the money you want when you want it, then repay only the amounts you borrow.
You now have two mortgage payments to make each month – your first mortgage payment and the new HELOC.
To qualify for a HELOC, you need to have equity in your home. Depending on your creditworthiness and how much debt you have, you may be able to borrow up to 85% of the appraised value of your home after you subtract the balance of your first mortgage.
For example, let’s say your home is worth $300,000 and the balance on your mortgage is currently $200,000. A HELOC could make it possible for you to borrow up to $255,000, because you would still retain 85% equity after accounting for your first mortgage and your HELOC.
Generally speaking, HELOCs work a lot like a credit card. You typically have a “draw period” during which you can take out money to use for any purpose. Once that period ends, you may have the option to repay the loan amount over a specific amount of time or you might be required to repay the balance in full.
Like credit cards, HELOCs also tend to come with variable interest rates, so you should be prepared for some rate volatility.
Before you decide between a HELOC or a cash-out refinance, it helps to do some analysis on your personal finances and your overall goals.
A cash-out refinance may work better if:
- Your current home loan has a higher rate than you could qualify for now, so refinancing could help you save on interest
- You need more than $50,000 overall
- You prefer the stability of a fixed monthly payment or only want to make one mortgage payment every month
- You have high-interest debts and want to consolidate them at the same rate as your new mortgage
- What you save by refinancing — such as savings from a lower interest rate — outweighs the fees that come with refinancing
- You are able to roll your closing costs/fees into the new loan amount so there are no out-of-pocket costs
A HELOC may work better if:
- You are happy with your first mortgage and don’t want to trade it for a new loan
- You need less than $50,000 overall
- Your first mortgage has a lower interest rate than you can qualify for with today’s rates
- You aren’t sure how much money you need, so you prefer the flexibility of having a line of credit you can borrow against
- You want to be able to borrow up to 85% of your home’s value versus the 80% you can borrow with a cash-out refinance
Here’s a quick “snapshot” of two different options – notice how the smaller transaction works well with the HELOC, the larger one with the refinance.
As you can see, for the smaller transaction, the HELOC is less expensive overall – both in fees and monthly payment. However, once you go over the $50,000 mark in cash-back, it appears that the cash-out refinance is the most economical, all things considered.
HELOC Pros and Cons
- Applying for a HELOC allows you to maintain the terms of your original mortgage, which can be an advantage if your rate is low.
- You can use money from a HELOC for anything you want, and you only have to repay amounts you borrow.
- HELOCs tend to come with lower closing costs than traditional mortgages and home equity loans.
- HELOCs can generally be closed quicker than refinances
- Taking out a HELOC means you’ll need to make two housing payments every month — your first mortgage payment and your HELOC payment.
- Interest on a HELOC is no longer tax-deductible, unless the funds are used for acquisition or updating your home.
- They are more expensive the more you borrow – if you are needing more than $50,000, your payments might be higher than that of a refinance
- Since you only repay what you borrow and the interest rate on HELOCs is typically variable, you may not be able to anticipate what your monthly payment will be. Your monthly payment could also be interest only at first, meaning your payment won’t go toward the principal or help pay down the balance of your loan.
- The interest rate on HELOCs tends to be higher than first mortgages, and their variable rates can seem riskier. You may also be required to pay a balloon payment at the end of your loan, so make sure to read and understand the terms and conditions.
Refinance Pros and Cons
- You can use the money from a cash-out refinance for anything you want, including home upgrades, college tuition, a vacation or debt consolidation.
- If rates have gone down or your credit has improved since you took out your original home loan, you could refinance your mortgage into a new loan with a lower interest rate.
- You can choose from different types of loans for your refinance, with various terms and fixed or variable rates available.
- Interest on your first mortgage may be tax-deductible.
- Interest rates on first mortgages tend to be lower than other options, such as home equity loans or HELOCs.
- Closing costs for a cash-out refinance are typically higher than those of a HELOC
- If interest rates have gone up since you purchased your home, you could be trading your mortgage for a higher interest loan that will be more expensive.
- Refinancing your home to take cash out may leave you in mortgage debt longer.
- You won’t qualify for a cash-out refinance unless you have at least 80% equity in your home after the process is complete.
As you can see, there’s really no right or wrong decision to be made here, but it is important that you know the benefits and drawbacks of both options. Please do reach out to me for more information, as I’d be happy to go over the specifics of your scenario to find the best option.