If you are like millions of Americans who need cash for home improvements, renovations, and paying back debt, tapping into your home equity is often an excellent idea. This means borrowing against the equity you already built up in your home through home equity loans, home equity line of credit (HELOC), or cash-out refinances.
In this article, we will analyze these three options and how they differ.
What is a home equity loan?
A home equity loan allows you to borrow money at a fixed rate. Since it’s essentially a second mortgage, you’ll have to submit payments every month in addition to paying back your existing mortgage.
When you apply for a home equity loan, the amount you can borrow is based on the difference between your mortgage principal balance and the home’s market value. Lenders also factor in your loan-to-value ratio (LTV) when sizing the equity loan. Generally, lenders prefer an 80%-90% combined loan-to-value (CLTV) ratio. Let’s look at an example.
If your home is appraised at $500,000 and you still owe $300,000, the maximum loan amount you can take out, based on an 80% CLTV, will be $100,000. Based on a 3.5% mortgage interest rate and a 20-year loan term, you will need to pay back $579.96 per month on top of your current mortgage payments.
Remember, your current LTV must be below 80% for you to be eligible for a home equity loan, and like most mortgages, home equity loans come with closing costs. If you only need a small amount of cash, a home equity loan might not be your best option, as most lenders won’t offer you anything less than $25,000. Instead, you might want to consider getting a HELOC.
What is a HELOC or home equity line of credit?
Home equity lines of credit, commonly called HELOC, serve as a revolving source of funds for homebuyers who might need additional cash to cover expenditures and debt. While you still borrow against the home equity you’ve accumulated, you don’t receive a lump sum of money. Instead, you gain access to a line of credit backed by the amount you have in your house.
Even though a HELOC is also considered a second mortgage, it works more like a credit card. For example, if you are approved for a $50,000 home equity line of credit, you can easily access it when you want for the amount that you choose simply by writing checks or through a credit card connected to your account within the draw period. Most lenders set a minimum draw amount, which means you may have to take out a minimum amount even if it is more than you currently need.
Unlike home equity loans, HELOCs often come with adjustable interest rates, and so your rate might go up and down according to the market condition. You only need to pay interest on the amount withdrawn during the draw period and not the whole loan. You won’t have to pay back the principal until the repayment period starts.
The loan amount of a HELOC, just like home equity loans, is determined by your current loan balance and the value of the home, as well as your LTV.
What is a cash-out refinance?
Unlike getting a second mortgage, a cash-out refinance lets you borrow money by replacing your existing mortgage with a new one. Generally, the new mortgage is always larger than your previous mortgage, allowing you to receive the difference in cash.
The process of getting a cash-out refinance is just like getting a traditional mortgage. Lenders will ask you to submit proof of income, tax returns and will make a hard inquiry on your credit report. They will also order an appraisal to determine the market value of your property. Depending on the lending requirements, your lender may allow you to borrow up to 80% to 85% of the appraised value.
For instance, say you owe $300,000 on your current home, and it’s now worth $600,000 based on the appraisal. Using an LTV of 80%, you can refinance up to $480,000 and pocket approximately $160,000 after covering potential closing costs.
Which one is better?
To find out which equity borrowing option is better for you, start by checking how much equity you have accumulated on your home.
You can arrive at the amount by subtracting how much you still owe from the current market value of your home. If this amount is positive, congratulations, you’ve accumulated equity. If, however, the number comes back negative, that means you owe more than what your property is worth, and you won’t qualify for either of the options.
Here are a few questions to ask yourself when deciding whether a second mortgage or a cash-out refinance is right for you.
How much do you want to borrow?
If you’re looking to borrow only a small amount of money, a home equity loan might be your best option, as you will receive a lump sum of cash at closing and the closing costs are lower than a cash-out refinance. However, if you are taking on major renovation projects or have other needs for a large amount of cash, cash-out refinance might be better for you.
What do you want to do with the money?
If your plan is to take on smaller projects over multiple years and only need a small amount of cash each time, getting a HELOC might be better overall. HELOCs are helpful for borrowers who need money for short-term needs or a supply of funds over a certain period.
What are the current interest rates?
Remember, HELOCs often come with adjustable rates, and so if interest rates are on the rise, a HELOC might end up hurting you financially more than helping. If the current rates are lower than your mortgage interest rate, it might be a good time to refinance.
When do you have to pay it back?
The repayment timeline can extend up to 30 years with cash-out refinancing, just like with traditional mortgages. With a cash-out refinance, you may decide to keep your current loan term or refinance into a shorter or lengthier loan term. Remember that your new loan term will impact your monthly payments.
With a HELOC, you do not have to make any payment on the principal but only on the interest during the draw period. The draw period is often for ten years. Once in the repayment period, you will need to make payments on both the interest and principal. A standard HELOC repayment period is usually 20 years. When combined, a HELOC may extend up to 30 years.
Which one is easier to qualify for?
A cash-out refinance is usually easier to qualify for compared to a second mortgage. Since a cash-out refinance replaces your current mortgage, it gives the lender the senior position when it comes to loan repayments.
Home equity loans and HELOCs, on the other hand, are usually considered second mortgages. What this means is that you are adding a mortgage to your primary mortgage. The lender is second in line to your primary lender regarding payback priority.
To borrow against your home equity, remember first to evaluate your financial needs, current loan rates, and the amount of equity you’ve accumulated on your home. If you want to receive a large amount of cash at once, a cash-out refinance or home equity loan might be what you need. Both allow you to take out a lump sum of money, but the amount differs depending on your equity. If you hope to tap into a pool of cash and receive small infusions over several years, a home equity line of credit might ultimately be your best option.