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Home equity loan or HELOC vs. cash-out mortgage refinance

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Home equity loans, home equity lines of credit and cash-out refinances have varying features as well as their own pros and cons. Deciding which type of home equity product is best for you depends on how much equity you have, how much and for how long you want to borrow, your intended loan purpose, your current mortgage interest rate and the repayment terms that work best for you.

HELOC and home equity loan vs. cash-out refinance

Home equity line of credit (HELOC) Home equity loan Cash-out refinance
Best for Borrowers who want access to funds for ongoing projects or in case of emergency Borrowers who want fixed payments and know how much they need Borrowers who want to (potentially) lower their monthly mortgage payment, access to funds and know how much they need
Features Credit line with variable interest rate Second mortgage with fixed interest rate New mortgage with fixed or adjustable interest rate
Equity requirement 15%-20% 15%-20% 20%
Loan term 10 years-20 years or 30 years 5 years-30 years Up to 30 years
Repayment structure Interest-only payments during draw period, then interest and principal payments Principal and interest payments Principal and interest payments
Closing costs and fees Closing costs generally lower than a home equity loan, with potential to waive if HELOC open for a period of time; annual and early termination fees 2%-5% of principal 2%-5% of principal
Current interest rates HELOC rates Home equity loan rates Cash-out refinance rates

Home equity is the percentage of your home you own. It’s calculated by subtracting your outstanding mortgage balance from the value of your home and is expressed as a percentage. For example, if your outstanding mortgage balance is $100,000 and your home is valued at $200,000, you have 50 percent equity, or $100,000, in your home.

To borrow against the equity in your home, a lender typically requires that you have at least 15 percent to 20 percent equity in your home. There are various ways to tap your home’s equity, including taking out a lump-sum home equity loan, a home equity line of credit (HELOC) or a cash-out refinance.

Because your home is used as collateral whenever you use one of these mortgage loan products, it’s less risky for a lender. As a result, you might receive a lower interest rate than an unsecured form of debt, like a credit card. However, if you default on the loan, a lender can foreclose on your home.

Although you can use home equity loan funds for any purpose, common uses include refinancing high-interest debt or paying for home improvement projects.

HELOCs: Overview

A HELOC is a revolving, open line of credit at your disposal, which functions much like a credit card — you are able to use it as needed. However, a HELOC has some benefits over credit cards.

“Typically, the available balance you can spend on a HELOC is higher than a credit card, and the interest rates are lower than credit cards,” says Michael Foguth, president and founder of Foguth Financial Group, based in Michigan, “but a HELOC still has to go through underwriting like a typical mortgage because you’re using equity in [your] home to back up the loan.”

HELOCs generally have a variable interest rate and an initial draw period, which can last as long as 10 years. During that time, you make interest-only payments. Once the draw period ends, there’s a repayment period, when interest and principal must be paid.

With a line of credit, however, it can be easy to get in over your head with a HELOC, using more money than you really need to use or are prepared to pay back. The variable payments can also be challenging to keep up with.

Home equity loans: Overview

A traditional lump-sum home equity loan allows you to borrow a specific amount, or a lump sum of money. The loan is a second mortgage and does not impact your existing mortgage. The money borrowed is repaid over a set period of time typically ranging from five to 30 years, at a fixed interest rate.

However, you typically end up paying a higher interest rate for a home equity loan than a cash-out refinance.

“It has to be that way because the lender is taking more risk,” says Foguth. “The home equity loan takes a second position to your mortgage. If you default, the lender who holds your mortgage gets their money back before the lender who provided the home equity loan.”

Cash-out refinancing: Overview

A cash-out refinance is an entirely new loan that replaces your existing mortgage with a new mortgage that’s larger than your current outstanding balance. You receive the difference in a lump sum of cash when the new loan closes.

This option appeals to homeowners who want to refinance and take out cash at the same time.

A major downside, however: If mortgage rates have increased since you took out your original mortgage, you could pay more interest over the life of the loan. In addition, if the equity in your home falls below 20 percent after doing the refinance, a lender might charge you private mortgage insurance (PMI).

Calculating combined loan-to-value (CLTV) ratio

One of the most important factors impacting your ability to obtain a home loan is what’s known as the combined loan-to-value (CLTV) ratio. The CLTV is the borrower’s overall mortgage debt load, expressed as a percentage of the home’s value.

Lenders calculate the CLTV by adding up all mortgage debt and dividing the total by the home’s current appraised value:

Formula: Amount owed on primary mortgage + Second mortgage / Appraised value

Example:

  • Morgan owes $60,000 on his first mortgage and wants to take out a HELOC for up to $15,000. His home is worth $100,000. The CLTV is 75 percent: ($60,000 + $15,000) / $100,000 = 0.75

Lenders take the CLTV ratio into account when considering whether to approve your home equity loan application.

When should I choose a home equity loan?

  • You want predictable monthly payments: If you want the peace of mind of knowing exactly what your payment will be each month, a home equity loan might be the right choice.
  • You can afford to make a second mortgage payment each month: Taking out a home equity loan means you will be making two monthly home loan payments: one for your original mortgage and one for your new equity loan. Before you sign on the dotted line, crunch the numbers to be sure you can actually afford the additional payment.
  • You want to access your home’s equity without changing the terms of your mortgage: A cash-out refinance replaces your existing mortgage with a new one, resetting your mortgage term in the process, which might not be ideal for everyone. A home equity loan does not reset the terms of your original mortgage.

When should I choose a cash-out refinance?

  • You need stability in your budget: With a HELOC, your monthly payments can vary substantially, particularly when you transition from making the interest-only payments during the draw period to the repayment period, when you must pay back the principal as well. A cash-out refinance might help you avoid this challenge.
  • You want to improve your interest rate: If you initiated your mortgage at a time when interest rates were higher and rates have since declined, a cash-out refinance could allow you to obtain new, more favorable terms.

Bottom line

Taking out any kind of loan against your home is a big decision. Before deciding how to use your home equity, consider the following:

  • A home equity loan deposits all funds upfront, and you must repay the loan with a fixed interest rate. This might be a good option if interest rates are low.
  • A HELOC works like a credit card, allowing you to pull funds when you need them and pay them back after the draw period ends. HELOCs have variable interest rates, but some home equity lenders allow you to lock in a rate on some or all of your balance for a fee.
  • A cash-out mortgage refinance replaces your mortgage and will usually extend your term, but it might be the right choice for homeowners who need cash but have also been planning on refinancing.

If you choose to borrow against your home equity, make sure you can afford to repay the debt. Keep in mind that if you default on the loan, a lender can foreclose on your home.