Home Equity Loan Or HELOC Vs. Cash-Out Refinance

The Fed finally began cutting rates in September and continued to do so at its most recent meeting in November. HELOC interest rates and home equity rates have fallen accordingly. In fact, borrowing has never been more affordable relative to the value of your home than in the past year.

People are paying attention. Mortgage holders collectively withdrew approximately $48 billion in home equity in the third quarter of 2024. This is the largest amount in the last two years. “With recent interest rate reductions, homeowners may be tempted to unlock equity in their homes to access capital,” said the platform for short-term vacation rental owners and property managers. says Tim Choate, founder and CEO of RedAwning.com.

“Whether you choose a home equity loan, a HELOC, or a cash-out refinance is not a one-size-fits-all decision,” Choate added. “Each option has unique characteristics tailored to different financial needs, risk profiles and flexibility requirements.”

Let’s take a look at these differences and how to weigh a home equity loan versus a HELOC versus a cash-out refinance.

How to utilize your home’s assets

There are three main ways to access your home equity and turn it into cash. Home equity lines of credit (HELOCs), home equity loans, and cash-out refinances. These are all loans secured by your home. That is, it is backed by an asset (i.e. a residence). All are good sources if you need a large amount of money, at least a five-figure loan.

A cash-out refinance is essentially a mortgage with benefits. This means replacing your current mortgage with it. The other two are loans available in addition to your primary home loan.

HELOC: Overview

A home equity line of credit (HELOC) is a revolving, open line of credit that works like a credit card, allowing you to pay it back and borrow again as needed. However, HELOCs have some advantages over credit cards.

“The available balance on a HELOC is typically higher than a credit card, and the interest rate is lower than a credit card,” says Michael Fogus, president and founder of Howell, Michigan-based Fogus Financial Group. Because HELOCs use the equity in your home to back the loan, they must go through the underwriting process just like a regular mortgage. ”

HELOCs typically have variable interest rates and an initial withdrawal period that can last up to 10 years. During that time, you can withdraw your funds and make interest-only payments. At the end of the drawing period, there is a repayment period in which interest and principal are repaid over another 10 to 20 years.

However, if you have a line of credit, you may end up spending more money than you really need. It can be difficult to adapt to changes in your payments.

When should I choose a HELOC?

Draw at your own pace. With a HELOC, you can withdraw cash as often as you need. Home equity loans and cash-out refinances only offer lump sum payments.

You can make a second payment each month. Since you can use a HELOC on top of your current mortgage, you’ll need to be able to afford the additional monthly bills.

Even variable interest rates are fine. HELOC interest rates fluctuate, so your interest rate may increase. Only consider a HELOC if you can accommodate that.

“In a declining rate environment, the volatile nature of HELOCs may initially result in lower monthly payments, but borrowers should be mindful of the possibility of subsequent rate hikes,” Choate says. “For people with intermittent financial needs, such as a series of small renovations or regular tuition payments, a HELOC is ideal because it allows access to funds over an extended period of time without having to reapply.”

Home Equity Loans: Overview

A home equity loan allows you to borrow funds in a lump sum. This loan is essentially a second mortgage. The money is repaid at a fixed interest rate over a set period of time, usually ranging from 5 to 30 years.

However, you typically end up paying higher interest rates on home equity loans than on mortgages. “It has to be because lenders are taking on more risk,” Fogas says. “A home equity loan is second only to a mortgage. If you default, the lender who holds the mortgage gets your money back before the lender who gave you the mortgage gets your money back.”

When should I choose a home equity loan?

If you want predictable monthly payments: Similar to a primary mortgage, the same amount is paid every month over the life of the loan. “It’s particularly advantageous for borrowers who want to avoid market fluctuations that can increase repayment costs over time,” Choate says. “With interest rates becoming more attractive, this option is suitable for large one-off expenses such as home renovations or debt consolidation.

I can afford to pay my second mortgage every month. Taking out a home equity loan means making two mortgage payments each month: the original mortgage and the new equity loan. Before you sign on the dotted line, crunch the numbers to see if you can actually afford the extra payment.

If you don’t want to change the terms of your mortgage: Home equity loans exist alongside your mortgage and do not affect your mortgage in any way. They are different animals, except they use the same real estate as collateral. In contrast, a cash-out refinance replaces your existing mortgage with a new mortgage and resets your mortgage term in the process, which may not be ideal for everyone.

Cash-Out Refinance: An Overview

A cash-out refinance is an entirely new loan that replaces your existing mortgage with a larger mortgage. You will receive the difference in cash in one lump sum when your new loan closes.

A cash-out refinance is essentially a mortgage with benefits. This means that you will be replacing your current mortgage with it. In contrast, home equity loans and HELOCs are debt added to a primary mortgage.

“This option is perfect for those looking to secure a single loan at a lower fixed rate than their existing home loan, with the added benefit of cash access,” Choate says. “With recent interest rate cuts, homeowners who locked in high interest rates years ago could greatly benefit from this option if they plan to stay in their home for a long time.”

However, there is a major drawback. If interest rates have increased since you took out your first mortgage, you could end up paying more interest over the life of your loan. Additionally, if your home equity drops below 20% after refinancing, your lender may charge you private mortgage insurance (PMI).

When should I choose a cash-out refinance?

I want to improve the terms of my mortgage loan.: If interest rates have fallen since you started your mortgage, you may be able to get a better rate with a cash-out refinance. You can also extend or shorten the term of your mortgage.

You prefer to keep it simple: With a cash-out refinance, your mortgage payment and loan payment are all rolled into one, meaning you pay off both at the same time. HELOCs and home equity loans are separate, and additional payments must be tracked.

You need to stabilize your budget. With a HELOC, your monthly payments can fluctuate significantly, especially if you move from paying only interest during the withdrawal period to a repayment period where you also have to pay back the principal. Cash-out refinances provide long-term, fixed-rate financing at lower interest rates than home equity loans.

“Cash-out refinances are especially popular right now because they often have lower interest rates than home equity loans or HELOCs and allow you to consolidate your debt into one payment,” said Chris Heller, president of Movoto Real Estate, an online real estate brokerage. It’s fascinating.” and a listing platform. “However, higher closing costs and the possibility of extending the loan term are considerations.”

HELOC vs. Home Equity Loan vs. Cash-Out Refinance

Calculate how much money you have in your home

Home equity is the portion of your home that you own outright. Home equity can be calculated as a number or a percentage of your home’s value.

For example, if your mortgage balance is $150,000 and your home is appraised at $450,000, you have $300,000 equity.

To find your home equity percentage, divide that amount by the value of your home and then multiply by 100. In the example above, you would have almost 67% equity in your home.

It is useful to know both numbers. Most lenders require that you have a certain percentage of equity in your home before they can begin occupying it. It also requires that a portion of it (at least 15-20 percent) remain intact. This means your loan balance can’t exceed 80 to 85 percent of your home’s value. In other words, you can’t use up all of your stock.

The dollar value of the stock also affects how much you can borrow. Two people, one who owns a $500,000 home and the other a $1 million home, have vastly different amounts of access, even if they both own 50 percent equity. . The dollar values ​​of their shares are $250,000 and $500,000, respectively. There is also a minimum amount of capital that the lender requires you to maintain. Assuming the lender requires 20% equity, first homeowners can borrow up to $200,000. The second is up to $400,000.

Composite loan-to-value (CLTV) ratio calculation

One of the most important factors that affects your ability to obtain a mortgage is something called the composite loan-to-value (CLTV) ratio. CLTV is calculated as the amount of debt backed by a property as a percentage of its value.

Lenders calculate CLTV by adding up all debts (current and future) and dividing that sum by the current appraised value of the home.

Let’s say you owe $60,000 on your first mortgage and want to open a HELOC for up to $15,000. Your house is worth $400,000. CLTV is 18.75 percent: ($60,000 + $15,000) ÷ $400,000 = 18.75

Lenders consider your CLTV ratio when considering whether to approve your mortgage application.

What are the tax implications of tapping into the equity in your home?

Home equity loans, HELOCs, and cash outflows all bring in money, but no taxes. These are considered debts, not income.

In fact, just like a home loan, you can receive tax benefits. But only under certain conditions.

Interest paid on a home equity loan or HELOC is deductible if the loan proceeds are used to “purchase, construct, or substantially improve” the home securing the debt. You must itemize deductions on your tax return (instead of taking the standard deduction).

There are also limits on the amount of interest that can be deducted. Joint filers and single filers can deduct up to $750,000 in interest on qualified loans, while the limit for married taxpayers filing separately is $375,000. Please note that these thresholds apply to all mortgages at once. Therefore, if you have a mortgage, and For home equity loans, the total amount deductible cannot exceed $750,000.

When it comes to cash-out refinances, things get a little more complicated. Interest on the loan portion that replaces the mortgage is tax deductible just like the previous loan. cash out part It was done Deductible – As mentioned above, if you use it to repair or upgrade your home. However, this is not the case if you use the money for other purposes, such as debt repayments, emergency expenses, or business activities.

Final Conclusion on Home Equity Loans/HELOCs and Cash-Out Refinances

In summary, which home equity product is best for you depends on several factors.

• how much capital do you have
• How much money do you need and when do you need it?
• your intended loan purpose
• current mortgage interest rate
• Nature of repayment terms

Home equity loans are perfect if you want low interest rates, stable monthly payments, and you know exactly how much you need to borrow. A HELOC is a good option when interest rates are low, you need the money for a long time, or you don’t have an exact amount in mind. However, be prepared for your payments to skyrocket if interest rates rise.

Cash-out refinancing is a little different. It actually replaces your mortgage. This is useful if you need cash right away and want to change the terms of your mortgage. However, while they offer financing at significantly lower interest rates than home equity loans or HELOCs, obtaining them is a more complex and expensive process.

Whatever option you choose, remember that you could lose your home if you default on your loan. Therefore, it is important to have a repayment plan in place.