Home equity loan, HELOC or cash-out refi?
Homeowners who want to cash out their equity might be puzzled by the advantages and disadvantages of their three choices: a home equity line of credit, home equity loan or cash-out refinance.
Which makes the most sense?
The answer depends on:
- How much equity you have.
- How much you want to borrow.
- When you plan to repay the money.
- Whether you want a fixed or flexible term.
- The interest rate on your current mortgage.
Home equity line of credit
A home equity line of credit, or HELOC, is a credit line secured by your home.
Most HELOCs have an adjustable rate, interest-only payments and 10-year "draw" period, during which the borrower can access the funds, explains Jay Voorhees, broker and owner of JVM Lending, a mortgage company in Walnut Creek, California.
After the draw period ends, the outstanding balance must be repaid. Typically, the repayment period is a 15-year term with a fixed or variable rate.
Voorhees says that homeowners can qualify for HELOCs if they have adequate income relative to their monthly debt obligations. They can find this type of financing for 80 percent of combined loan to value or even 85 percent or 90 percent combined loan to value.
Combined loan to value, or CLTV
Lenders calculate the combined loan to value by adding all mortgage debt together and dividing by the home’s current appraised value.
Formula: (Amount owed on primary mortgage + second mortgage) / appraised value
Example: Morgan owes $60,000 on the primary mortgage and has a HELOC for up to $15,000. The house is worth $100,000. The CLTV is 75%: ($60,000 + $15,000) / $100,000 = 0.75
Uses and temptations of a HELOC
A HELOC can be a good way to borrow a relatively small sum for a relatively short time compared with a first mortgage, says Justin Lopatin, vice president of mortgage lending for PERL Mortgage in Chicago. An example might be $20,000 that you plan to repay within three to five years.
It can be "very tempting" to access a HELOC even if it's not necessary, a disadvantage of this type of financing, says Alan Moore, a CFP professional at Serenity Financial Consulting in Milwaukee.
"You have to carefully consider: What are your long-term goals? What is the money for?" Moore says. "Realistically, having easy access to money is not always a good thing."
Home equity loan
Like a first mortgage, a home equity loan allows you to borrow a specific sum for a set term at a fixed or variable rate. That's why these loans are sometimes called second mortgages.
Home equity loans aren't common today, yet some banks still offer them.
Banks offer hybrid equity loans
An alternative is a HELOC that's structured like a fixed-rate home equity loan.
Kelly Kockos, home equity product manager for Wells Fargo in San Francisco, says the bank offers a HELOC with a fully amortizing payment, which means the loan is repaid in full if all the payments are made through the draw period.
"With every payment you make, you pay down a little bit of principal and a little bit of interest so when you get to the end of your draw period, you don't have a big payment shock," Kockos says.
A fixed-rate advance option allows the borrower to lock in a portion of the credit line at a fixed rate and term. If interest rates change, the advance can be unlocked to float down to a lower, current rate, Kockos says.
A cash-out refinance is an entirely new first mortgage with cash back.
This option often appeals to homeowners who want to refinance for other reasons and decide to take out cash at the same time.
"It's a good way to grab equity and keep it all in one loan," Moore says.
He cautions, however, that any loan or cash-out strategy must have a clear purpose. Don't take the cash just because you can.
Lenders typically limit the cash-out refinance to 80 percent of the home's value, Voorhees says.
Check fees as well as interest rates
It's important to compare closing costs and interest rates. Fees might be higher for a cash-out refinance than for a HELOC, while the interest rate might be lower for a cash-out refinance than for a HELOC, all other factors being the same.
The ability to lock in a low fixed rate is an advantage of a cash-out refinance, Voorhees explains.
"Whenever your payback period is going to be relatively slow, it behooves you to have a fixed rate because it's much safer," he says.
Your current rate matters
Your new monthly payment might be higher or lower than your current payment, depending on your interest rates, loan balances and repayment terms.
For example, if your existing loan has a very low rate, a cash-out refinance could mean your rate would be higher for your entire loan, not just the cash-out portion.
"If you bought (your home) in 2012 or 2013 and got a rate in the 3s, you may not want to touch that because it's such a pristine loan that can't be beat," Lopatin says. "If you purchased a few years ago and maybe haven't refinanced, it may make sense to roll everything into one loan."