Home equity loan versus a HELOC or cash-out mortgage refinance

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The pros and cons of home equity loans, including a home equity line of credit (HELOC), home equity loan and cash-out refinance, can be confusing to some borrowers.

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.
  • Whether you want a fixed or flexible term.
  • The interest rate on your current mortgage.

Home equity line of credit

A HELOC is a credit line secured by your home. Most HELOCs have an adjustable rate, interest-only payments for a specified time and a 10-year “draw” period during which the borrower can access the funds.

After the draw period ends, the outstanding balance must be repaid, typically over a 15-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.

Combined loan to value, or CLTV

Lenders calculate the combined loan to value by adding 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 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

The pros and cons of a HELOC

A HELOC can be a good way to borrow a small sum for a short time, says Justin Lopatin, vice president of residential lending at PERL Mortgage in Chicago. For example, you might borrow $20,000 that you plan to repay within three to five years.

One bad thing about a HELOC is it can be “very tempting” to access it, even if it’s not necessary, says Alan Moore, CEO of AdvicePay, a payment-processing platform for financial advisers.

“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 loans

A home equity loan, like a first mortgage, allows you to borrow a specific sum for a set term, often at a fixed rate. That’s why these loans are sometimes called second mortgages.

Home equity loans aren’t as common, but many banks offer them, and they do have the advantage of a fixed rate and payments.

Hybrid equity loans with fixed rates and terms

An alternative is a HELOC that’s structured like a fixed-rate home equity loan.

Some banks, like Bank of American and Wells Fargo, have begun offering HELOCs with fixed-rate conversion options. With these types of HELOCs, you can convert some or all of your HELOC into a fixed-rate loan, sometimes for a fee. This is a good option if you’d like to take advantage of low interest rates for part of your balance. Many banks offering these HELOCs let you take out as many as three fixed-rate locks at a time.

Cash-out refi

A cash-out refinance is an entirely new first mortgage with cash back when the loan closes. This option appeals to homeowners who want to refinance and 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, says Jay Voorhees, broker and founder of JVM Lending, a mortgage company in Walnut Creek, California.

Check fees and interest rates

It’s important to compare closing costs and home equity loan rates. Fees might be higher for a cash-out refinance than for a HELOC, but the interest rate might be lower for a cash-out refinance.

The ability to lock in a low fixed rate is an advantage of a cash-out refinance, Voorhees says. “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 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, 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.

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 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 also let you lock in a rate on some or all of your balance for a fee.
  • A home equity loan deposits all funds upfront, and you must repay the loan with a fixed interest rate. This may be a good option if interest rates are low.
  • 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.

Featured image by @maginnis of Twenty20.

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