Home equity loans, home equity lines of credit and cash-out refinances all have their own pros and cons. Determining which type of equity loan is best for you depends on several factors:
- How much equity you have
- How much you want to borrow
- When you plan to repay the money
- What you intend to use the money for
- Whether you want a fixed or flexible term
- What your current mortgage interest rate is
Generally, a home equity loan is best if you want predictable monthly payments, a HELOC is best if you have ongoing projects and a cash-out refinance is best if you currently have a high interest rate on your mortgage. Read on to learn more about these different types of financing and how to use them to your advantage.
Types of home equity loans
If you’ve been making regular payments on your mortgage, chipping away at the principal owed, or if the value of your home has increased over time, then you’ve likely built up equity. Equity is the difference between the value of your home and the amount still owed on your mortgage or any loans attached to the property.
There are various ways to access that equity when you need cash, including taking a lump sum home equity loan, a home equity line of credit (HELOC) or a hybrid equity loan.
A traditional lump sum home equity loan allows you to borrow a specific amount, or lump sum of money, as the name implies. The loan is a second mortgage and does not impact your existing mortgage. The money borrowed is repaid over a fixed period of time ranging from five to 30 years, at a fixed interest rate.
A home equity line of credit (HELOC) is a revolving, open line of credit at your disposal, which functions much like a credit card — you’re 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. “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.
The third type of home equity loan is a hybrid: a HELOC that’s structured like a fixed-rate home equity loan.
“This is often a HELOC where the interest rate on the drawn amounts can be locked in,” says Matt Hackett, mortgage operations manager at Equity Now. “It combines some of the better elements of each option.”
What is combined loan to value (CLTV)?
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 fair market value.
Lenders calculate the combined loan to value ratio 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 the primary mortgage and wants to take out 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
Lenders take the CLTV ratio into account when considering whether to approve your home equity loan application.
“The CLTV, along with an analysis of monthly income, monthly debt and other factors, will help determine if you qualify for a home equity loan, and if so, how much you may be eligible to borrow,” says Tiffany Brown, broker owner and loan originator for Motto Mortgage Summit.
What is a home equity loan?
A home equity loan is a lump-sum loan secured by the equity in your home. It acts as a second mortgage on your property, meaning it doesn’t impact your existing mortgage or change the terms.
The entire proceeds of a home equity loan are disbursed at closing, and the repayment period ranges from as little as five years to as long as 30 years. A home equity loan can be used for anything from renovation projects to debt consolidation.
- The pros of a home equity loan
Home equity loans offer stable, fixed monthly payments and a fixed interest rate. In addition, they provide a large sum of cash up front.
“This is a good option when the full amount of the funds are needed right away and the exact amount needed is known,” says Hackett. “A large purchase such as a boat might be an example.”
- The cons of a home equity loan
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.”
You will also pay closing costs on a home equity loan, which can be expensive. And if you’re not able to keep up with the payments on the home equity loan, you risk losing your house.
What is a HELOC?
A HELOC is a line of credit that is secured by your home equity. It is a second lien on your home. Your first mortgage stays in place and the HELOC is added as a second loan.
Most HELOCs function similar to a credit card, providing access to a revolving source of funds during the draw period, which lasts about 10 years. During this time, you’re only required to make interest payments on the debt incurred.
After the draw period ends, the outstanding balance must be repaid, typically over a 15- or 20-year term.
Homeowners with adequate income who don’t tip the debt overload scale can qualify for this type of loan. They can usually find this type of financing for 80 percent of combined loan to value or even 85 percent or 90 percent combined loan-to-value.
- The pros of a HELOC
By establishing a HELOC, you access the funds only when they’re needed and untapped funds will not incur interest. You only pay for what you use.
“If you don’t use the funds, you may not have to make payments, though there may be a modest monthly maintenance fee to keep the line open,” says Brown. In addition, HELOCs typically have lower closing costs than other home equity loans. They can also be a great source of emergency funds.
- The cons of a HELOC
With a revolving line of credit, 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.
“Often the principal and interest payment in the repayment phase increases dramatically over the interest-only payment amount during the draw period, which can cause payment shock for the unprepared borrower and may even cause financial hardships,” says Brown.
What is a hybrid equity loan?
Yet another option is a HELOC that’s structured like a fixed-rate home equity loan.
“A hybrid equity loan takes features of a HELOC and a home equity loan and combines them,” says Jon Giles, head of home equity lending for TD Bank. “Similar to a HELOC, borrowers receive a revolving line of credit with a variable interest rate as well as a HELOC’s flexible spending terms.”
Once a borrower draws on the line of credit provided by a hybrid equity loan, they can set a fixed interest rate on a portion of the balance, locking in a fixed monthly payment until the balance is paid off, adds Giles.
Some banks have begun offering HELOCs with fixed-rate conversion options. They can be a good choice if you’d like to take advantage of a low interest rate for part of your balance.
- The pros of a hybrid equity loan
A hybrid equity loan can be an attractive option when interest rates are particularly low because it allows you to lock in a favorable rate and monthly payments will remain the same over time.
“This means that as interest rates rise and fall with the market, the borrower’s payment remains the same,” says Giles.
- The cons of a hybrid equity loan
The interest rate you’ll pay on the fixed portion of a hybrid equity loan is often higher than what you’d pay on a cash-out refinance.
Things to consider before picking a home equity loan
The right type of home equity loan depends on your needs and financial situation. Here are some things to consider when comparing products:
- Check fees and interest rates. When comparing lenders and products, consider both interest rates and closing costs. Fees might be higher for a cash-out refinance than for a HELOC, but the interest rate might be lower.
- Your current interest 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 mortgage has a very low rate and you go for a cash-out refi, you could end up paying a higher rate on your entire loan, not just the cash-out portion.
- Beware of market volatility. In times of financial crisis, like the coronavirus pandemic, home equity products are likely to take a hit. Lower loan amounts, tighter eligibility requirements and even limited offerings are all tactics lenders may implement to protect themselves in an economic downturn. Many lenders may also stop offering products like home equity loans and HELOCs altogether in these times, so it’s important to keep an eye on how rates change and how lenders respond to market volatility if you’re considering tapping your home equity.
What is a cash-out refinance?
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.
“This differs from a rate and term refinance, which replaces your existing mortgage loan with a new one for the same balance, or the same balance plus closing costs,” says Brown. With a rate and term refinance, you’re not getting any cash out. You’re only making changes to the length of the loan, the interest rate on the loan or both.
Features of home equity loans and HELOCs vs. cash-out refinances
Here are some of the key differences between a home equity loan, a HELOC and a cash-out refinance.
|Loan type||Provides immediate cash at closing or access to cash via line of credit||Fixed interest rate||Fixed monthly payments|
|Home equity loan||Yes||Yes, most are fixed rate, but there are rare exceptions||Yes|
|HELOC||Yes||No, HELOCs typically have adjustable interest rates||No, during the draw period, you make interest-only payments. During the repayment period, the monthly amount due includes principal and interest|
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.
“A home equity loan has several pros, the main one being that it provides a fixed rate and fixed monthly payment for customers who prefer stability,” says Giles, of TD Bank.
- You can afford to make a second mortgage payment each month
Taking out a home equity loan means that 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 may not be ideal for everyone. A home equity loan does not reset the terms of your original mortgage.
“A home equity loan might be a good option when you want to access your home’s equity without affecting your primary mortgage loan because you don’t want to impact the length, the balance or the rate on your primary mortgage loan,” says Brown.
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 principal as well. A cash-out refinance avoids this challenge.
“A cash-out refinance offers the simplicity of maintaining a single payment, usually at a fixed rate and a longer term, which could translate into more stability in your budget,” says Sean Murphy, assistant vice president of equity lending for Navy Federal Credit Union.
- You want to improve your interest rate
If you initiated your home mortgage at a time when interest rates were higher and the rates have since declined, a cash-out refinance may allow you to obtain new, more favorable terms.
“A cash-out refinance is a good option for borrowers who want to adjust the interest rate of their overall mortgage, while obtaining additional cash for home improvements or remodeling, high-interest debt consolidation or a variety of other financial needs,” says Giles.
The 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 up front, and you must repay the loan with a fixed interest rate. This may 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 banks let you 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 mortgage terms, but it may be the right choice for homeowners who need cash but have also been planning on refinancing.