For many homeowners, having home equity is like having a large savings account. It represents a substantial cash reserve you can draw upon when needed. But what's the best way to access it?
Two of the most common ways are through a home equity loan/line of credit or a cash-out refinance. Each has certain advantages or disadvantages. The one that's best for you will depend on a variety of factors, including how much cash you need, when you need it, how quickly you can pay it back, the current market for mortgage rates and more.
What's the difference?
Both a home equity loan and a cash-out refinance are types of mortgages – loans secured by the value of your home. As such, you can take a tax deduction for the interest you pay on them, up to certain limits. A home equity loan is considered a type of second mortgage, in that's it's a subordinate loan to your primary mortgage. With a cash-out refinance, you still just have one, primary loan.
Home equity loans also come in two types – a home equity loan and a home equity line of credit, or HELOC. So that gives you three types of loans to choose from. Here's a brief look at each:
Standard home equity loan: You borrow a sum of money and immediately begin repaying it over a certain period of time, generally 5-15 years. Usually set up as a fixed-rate loan.
Home equity line of credit (HELOC): A more flexible option, this gives you a preset limit you can borrow against as needed, in whatever amounts you choose. A HELOC has a draw period, typically 5-10 years, when you can borrow money, and a repayment phase, often 10-20 years, when you pay back the principle. The draw period is usually an adjustable-rate, interest-only loan, while the repayment phase often switches to standard fixed-rate.
Cash-out refinance: You refinance your existing mortgage for a larger amount than the current balance you owe, and receive the difference in cash. For example, if you presently owe $100,000 on your mortgage and your home is worth $250,000, you might refinance into a new $150,000 mortgage and receive $50,000 in cash.
Of course, in order to borrow against your home equity, you need to have equity in the first place. Most lenders will want you to have at least 20 percent equity remaining after setting up the loan. So in the example above, if your home is worth $250,000, you could borrow up to $100,000 and still have $50,000 in equity left, which would be 20 percent. Some lenders may let you go less than 20 percent, but the cost of borrowing increases sharply at that point.
Comparing your options
As a general rule, a cash-out refinance is a good option if you can get a lower mortgage rate than you're currently paying. They're also a good pick if you need to borrow a large sum of money, because the rates are lower than on a standard home equity loan. At the same time, the closing costs are much higher, because you're refinancing your entire mortgage, rather than having them based on just the amount you're borrowing.
Standard home equity loans are good for more modest amounts, although you can still get them for well into six figures, if you have the equity. However, because they're second liens, their rates will be higher than what you'd pay on a cash-out refinance. But as noted above, their closing costs are considerably lower. They're typically repaid as fixed-rate loans, which makes their costs very predictable.
Home equity lines of credit, or HELOCs, are very flexible, which has made them a very popular choice. First, you can borrow what you need, when you need it – you have a line of credit you can draw against as you wish. Closing costs are very low, and sometimes zero – though you often have to pay an annual fee to maintain the line of credit.
HELOCs are usually interest-only during the draw phase, which keeps your payments low. During this period, you can also repay principle as you wish, which makes them a handy tool to manage cash flow for those with irregular incomes. However, because their rates are adjustable during this phase, their costs are less predictable.
A few other things to keep in mind when choosing among a home equity loan, a HELOC or a cash-out refinance:
How much do you need to borrow? If you only need to borrow a small amount, a HELOC may be your best bet. You only need draw as much as you need and you only pay interest on what you borrow. Lenders typically have minimums of $5,000-$25,000 on standard home equity loans.
How will you use the funds? If you're borrowing for a single expenditure, a cash-out refinance or standard home equity loan provides you with a single lump sum of money. But if you're going to need money periodically over a period of time, such as for a home improvement project, being able to draw against a HELOC as needed may make more sense.
How soon do you need the money? Home equity loans and HELOCs can usually be closed within 2-4 weeks, compared to 4-8 weeks for a cash-out refinance.
How long do you need to pay it back? Payments on a cash-out refinance can be stretched out over 30 years. As noted above, standard home equity loans usually have to be repaid in 5-15 years. With a HELOC, you can make interest-only payments for 5-10 years, and after that have 10-20 years to repay the principle.
Where are mortgage rates right now? If refinancing can get you a lower mortgage rate than you're currently paying, a cash-out refinance is a very attractive option regardless of how much you want to borrow. Just be sure you're reducing your rate enough to cover your closing costs.
Choosing among a home equity loan, HELOC or cash-out refinance can be a complicated decision. But if you take your time and consider your options carefully, you can make the right choice.