Home Equity Loan, or HELOC, vs. cash-out refinance: How to maximize your home’s worth
You have many options to access the home’s value. Consider these points when deciding which option is best for you.
Three ways to transform your home’s wealth into funds that you can use for other purposes, such as paying off debt or making home improvements, are home equity loans, cash-out refinances and home equity lines of credit.
Borrowing against your equity (the difference between the value of your house and what is left to pay for your mortgage) allows you to obtain the cash.
While these loans look very similar, they aren’t the same. A HELOC or home equity loan will not be available if you already have a mortgage. Cash-out refinances replace your current mortgage with a new one, complete with a different term, interest rate, monthly payment, and a new mortgage.
Start by looking at your home equity
Your equity in your home comes from the amount you pay down on your home loan. However, it can also grow from property appreciation. One way to turn that equity into cash is to sell your house. You can tap into the equity without having to sell your home. However, you will need to borrow against it through a home equity loan.
First, however, you must have sufficient equity in your home.
Estimate the value of your house and determine how much you owe on your mortgage to find out how much equity you have. If the difference is positive, it’s your equity in the home. You aren’t eligible for a cash-out refinance or home equity loan if your home is valued less than what you owe.
Understanding your options for home equity loans and HELOCs vs. refinances with cash-out
Although the qualifications of each lender will differ, if you have at minimum 15% equity in your home, you might be eligible for one of these loans. The basics of each loan:
Home equity loans
You can borrow a lump sum and then pay it back at a fixed-rate home equity loan. This is technically a second mortgage. You’ll have to make regular monthly payments as well as payments on the home equity loan. The exception is if you have a house that’s paid off and take out a home equity mortgage, this would be your primary mortgage.
Home equity line-of credit (HELOC).
The home equity line credit can also be a second mortgage, but it requires a monthly payment. You can borrow the money as you need it during the draw period, instead of getting all the cash at once. You will then repay the amount borrowed and pay interest over the repayment period. HELOCs come with an adjustable interest rate which means that your monthly payments may vary.
Your original mortgage is replaced by a cash-out refinance that provides a completely new loan, which is more than you owe. The “cash-out” refers to the difference in the amount of your current loan and the amount of the new loan. Even though cash-out refinances have higher rates than rate and term refinances in general, your interest rate is still likely to be lower than a HELOC rate or home equity loan.
- The similarities between home equity loans and HELOCs as well as cash-out refinances.
- For any of these, you’ll need an after transaction loan-to-value ratio less than 90%.
- You can borrow the money however you wish, although it is generally advised that homeowners only use their home equity for home improvements and debt consolidation.
- Your home is collateral. Failure to pay could lead to foreclosure.
What is the difference between home equity loans, HELOCs and cash-out refinances?
Cash-out refinances are typically cheaper than home equity loans or HELOCs in terms of interest rates.
Refinances that are cash-out are more expensive than those that are cash-in. This is because a mortgage refinance is almost a new mortgage. HELOCs and home equity loans typically have lower closing costs.
A cash-out refi leads to one, larger loan. However, a home equity loan (or line of credit) is an additional loan.
FAQ on home equity loans and HELOCs.
Is it better to take out a second mortgage, or refinance?
If you are considering a second mortgage (either a home equity loan of HELOC) over a cash-out refinance you should consider these things.
- Current mortgage rate: If refinancing would get you a lower rate, and you plan to stay in your home for long enough to reach break-even, then a cash out refi might be more sensible than a second loan.
- How much do you want to borrow? Are you looking to borrow a small amount of money. The home equity loan is a better option because you won’t be required to pay high refinance fees but you still receive the funds in a lump sum. You may not need to borrow as much money for home equity loans or HELOCs. If you are looking for liquidity, a low interest credit card or personal loan might suffice.
- Your plans and budget: HELOCs may be the best option for you if you don’t know how much money you’ll need, or if your project will unfold over a prolonged period of time. However, it is risky to use your home as collateral for a HELOC if you have unclear plans.
- How long will you live in your house? If you plan to move within a short time, a home equity mortgage might be more practical than refinancing and getting a HELOC. While a cash out refinance might offer a lower rate of interest, it may take you several years to recover any closing costs that you have already paid. HELOCs are also known for having a long life span. They can be drawn for 10 years and then repaid for 20 years. However, if your home is sold before the HELOC has been paid back, you will have to pay the remainder as a lump sum.
How much can you borrow?
There are many factors that affect the amount of money you can borrow for a home equity loan (or a HELOC) or cash-out refinance. Your credit score, the amount of your home equity and your loan-to–value ratio will all impact how much and at what rate a lender will allow you to borrow.
Additionally, you cannot borrow the entire value of your house. Your all-in loan debt should not exceed 90%.
When will you have to pay it back again?
Refinances can be extended up to 30 year for cash-out, just as a primary loan. Refinance to get cash out allows you to choose whether to extend your term, keep the original term, or reduce it. Cash-out refinances can increase your monthly payments, especially if you have a new loan with a shorter term or a greater amount than your original mortgage.
HELOCs don’t require payment during the draw period. While the draw period’s length is subject to change, 10 years is a common one. You may be able make monthly payments to the interest while you are in the draw period. When you are in the repayment period for a HELOC you will be making payments towards both the principal AND the interest. HELOCs have a longer repayment period than their draw periods. 20 years is the most common. This is combined with the draw term, which is a 30-year loan.
Home equity loans generally have shorter repayment terms and are available for a maximum of 15 years. You will pay less interest if the term is shorter than you need.
Are the proceeds subject to tax?
You realize home equity only after you sell your home. This is a form of profit, also known as a capital gain in tax jargon. Because it is borrowed money, the cash you get from a cash out refinance, HELOC and a home-equity loan isn’t taxable.
Is the interest paid exempt from tax?
HELOCs or home equity loans interest should be tax-deductible, provided that the funds are used for home improvement. The IRS requires that proceeds be used to “buy and build or substantially improve” the taxpayer’s home.
A cash-out refinance will be treated the same as any first-lien mortgage. The first $750,000 of the mortgage can be deducted interest if you itemize deductions in 2020.