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 all have their own pros and cons. Determining which type of equity loan is best for you depends on several factors:

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. However, everyone will want to consider their situation carefully to determine which is best for them.

Home equity and mortgage product overviews

Home equity is the percentage of your home you own. It’s calculated by subtracting your outstanding mortgage balance from the market 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 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 may 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.

Home equity loans

A traditional lump-sum home equity loan allows you to borrow a specific amount, or a 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 one to 30 years, at a fixed interest rate.

HELOCs

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. “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.

Cash-out refinance mortgages

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,” Brown says. 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.

Interest rates

Your interest rate is based on key factors, such as your creditworthiness and income. The type of interest rate you receive — adjustable or fixed —  depends on which home equity loan product you use.

Home equity loans

Home equity loans typically come with fixed interest rates. As a result, your monthly loan payments remain the same during the life of the loan.

HELOCs

Unlike a home equity loan, HELOCs often come with variable interest rates. The interest rate you receive fluctuates based on some benchmark interest rate, like the prime rate. As the benchmark rate goes up, your interest rate increases. Conversely, when it drops, your interest rate falls.

Cash-out refinance mortgages

When you take out a cash-out refinance mortgage, you have more control over the type of interest rate you receive. For instance, if you currently have a fixed-rate mortgage, you can apply for a variable-rate loan.

Key product benefits

A home equity loan, HELOC and cash-out refinance mortgage each comes with unique benefits.

Home equity loans

Home equity loans offer stable, fixed monthly payments and a fixed interest rate. In addition, they provide a large sum of cash upfront.

“This is a good option when the full amount of the funds are needed right away and the exact amount needed is known,” Hackett says. “A large purchase such as a boat might be an example.”

HELOCs

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,” Brown says. In addition, HELOCs typically have lower closing costs than other home equity loans. They can also be a great source of emergency funds.

Cash-out refinance mortgages

A cash-out refinance allows you to change the terms of your original loan, which could help you save money. For example, if you qualify for a lower interest rate or shorten the loan term, you could reduce the amount of interest you pay over the life of the loan.

In addition, repaying a cash-out loan requires a single monthly payment. This could be easier to budget for versus possibly having two monthly payments when using a HELOC or home equity loan.

Key drawbacks

Like all loan products, home equity loans, HELOCs and cash-out refinance mortgages also come with some disadvantages.

Home equity loans

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,” Foguth says. “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.

HELOCs

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,” Brown says.

Cash-out refinance mortgages

A major downside of taking out a cash-refinance mortgage is that you’ll likely have to pay more in closing costs versus using a HELOC or home equity loan. Also, 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 a cash-out refinance, a lender may charge you private mortgage insurance.

Features of home equity loans

Here’s a side-by-side comparison of the features of home equity loans, HELOCs and cash-out refinances.

Loan type Provides immediate cash at closing or access to cash via line of credit Fixed interest rate Fixed monthly payments Closing costs
Home equity loan Yes Yes, most are fixed rate, but there are rare exceptions Yes 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. Yes
Cash-out refinance Yes Yes, but it is optional. Yes Yes, if your new loan has a fixed rate

 

What is 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 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.

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.
  • 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,” Brown says.

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. “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,” Giles says.

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.

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.

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