For long-time homeowners, home equity can be a great way to tap into your home’s value to help pay for things like home improvement, debt consolidation, or even college tuition for a child.
A home equity loan or line of credit (HELOC) might be the first thing that comes to mind if you’re looking at ways to turn some of your home equity into cash — after all, “home equity” is right there in the name of these lending types. But right now, experts say there’s a better way for most people to use their home equity: cash-out refinancing.
No matter when or how you use your home equity for extra cash, it’s important to remember that you are essentially borrowing money against your home, which is used as collateral with this type of lending. That means if you fail to repay the amount you borrow, you could lose your home.
Here’s what you need to know about home equity lending, and why a cash-out refinance might be your better bet right now:
What Is a Home Equity Line of Credit (HELOC)?
Home equity lines of credit (HELOCs) are revolving lines of credit, like credit cards. They’re secured by your home, and traditionally work on a 30-year model with a 10-year draw period and 20-year repayment period. You can spend up to the amount of your line of credit during the draw period and then you will have 20 years to pay off whatever you spend (plus interest).
What Is a Home Equity Loan?
Home equity loans work like traditional loans. You’ll get a lump sum of money up front and then make monthly payments to pay off your loan (plus interest). You can use the funds from your home equity loan for whatever you want.
The average interest rate on a home equity line right now is around 4.68%, and fixed-rate home equity loans are well into the 5’s, depending on loan term, according to Greg McBride, chief financial analyst at Bankrate.com.
What Is a Cash-Out Refinance?
A cash out mortgage refinance is when you pay off your mortgage by getting a new one that’s larger than the one you currently have. You’ll get paid for the difference. At that point, you’ll have extra cash and a new mortgage, which you’ll pay down over time as you would have with the original, according to the terms of the new loan.
If your home is worth $250,000 and you owe $100,000 on the mortgage, you have $150,000 in equity. With a cash-out refinance, you might get a new mortgage for $200,000 — $100,000 more than you owe on the original mortgage. Subtract $12,000 in closing costs for the new mortgage, and you’d pocket $88,000.
Why Home Equity Loans Don’t Make Sense Right Now
Mortgage interest rates are lower right now than rates on home equity loans or HELOCs. So you might be able to pull equity out of your home and lower the interest rate on your regular monthly payments at the same time. Experts say that’s a smart move since the amount you’ll save on interest is far lower with a new mortgage — what you’re getting when you refinance — than with a home equity loan or (HELOC).
“If your current mortgage rate is three and a half percent, you’re not going to go out and take out a home equity line for four and a half, when you can instead refinance your first mortgage, and knock that rate down to maybe two and half percent,” says McBride.
After dropping to under 3% at the end of 2020, mortgage rates are slowly climbing back up, but are still much lower than they were a year ago before the pandemic. In early March, the average 15-year fixed mortgage rate — a good loan for many to use when refinancing — was still below 3.5%. Compared to the 4% average rate this loan type saw in July 2019, that is still a very low rate.
Using McBride’s example on rates, and the cash-out refinance breakdown from above, here’s exactly how much you’d save on interest by doing a cash-out refinance instead of taking out a home equity loan on top of your original mortgage:
|Principal||Interest Rate||Interest Paid|
|Home Equity Loan||$25,000||4.5%||$9,424.70|
All together, on top of a combined $125,000 in principal payments, you’d pay a total of $48,615.03 in interest by adding a home equity loan to your current mortgage. Now let’s say your home is worth $250,000 — $150,000 more than you own on it using the above example. Take out refinance closing costs on a new $200,000 mortgage worth 6%, or $12,000, and you’d still pocket $88,000.
|New Mortgage Principal||Interest Rate||Interest Paid|
Going the cash-out refinance route would save you $8,570.91 in interest compared to adding a home equity loan to your current mortgage. And aside from the rate advantage that comes with a refinance, home equity loans and HELOCs are tougher to qualify for right now than a refinance, McBride says.
What You Should Know Before You Refinance
Before refinancing, you should consider a few factors. Most importantly, you should know refinancing comes at a cost, at least until you recoup your loss. You’re getting a new mortgage to replace your old one, and this will come with new closing costs — 3 to 6% of the total value of the new mortgage. Another thing to keep in mind is the importance of refinancing into a shorter term, if possible, so as not to prolong the time you are paying a mortgage and the interest that comes with it.
You’ll want to have a handle on your credit score before you try to refinance. If your credit score has gone down since you got your current mortgage, you may not be eligible for a refinance at all.
As a baseline, it makes sense to refinance if you can get a new interest rate that is a full percentage point lower than your current one, says Darrin Q. English, a development loan officer at Quontic. So a move from 3.5% to 2.5% would be a good move using that baseline.
Consider your “recovery time.” For example, if you refinance and save $100 a month, and it costs you $2,000 to refinance, then you’ll recover and start saving from that refinance in 20 months.
“If you can recover from the cost of that refinance within two years, then absolutely [do it],” says English. But if the cost of your refinance takes you outside of a two-year period, and “you don’t have the monthly savings to make sense of it, then you probably want to stay put,” says English.
Know Your Options: HELOC, Home Equity Loan, or Cash-Out Refinance
While a cash-out refinance makes the most sense in terms of current rates, it’s not the only option. Home equity loans and home equity lines of credit (HELOCs) are common ways homeowners can tap into their home equity for things like home improvement, debt consolidation, or even paying for a child’s college tuition.
|Cash-Out Refinance||Home Equity Loan||HELOC|
|What Is It||A new mortgage that takes the place of your current mortgage||Traditional loan that uses your house as collateral||Revolving line of credit secured by your home|
|Length||Same as mortgage terms — usually 15 or 30 years||Vary depending on how big your loan is; generally 10-30 years||Traditionally work on a 30-year model with a 20-year draw period and 10-year repayment period|