Owning a home is part of the American Dream and home ownership is the bedrock of our economy. It is also, for most people, the biggest investment they will ever make and fortunately, owning a home has traditionally been a very good investment.
In addition to the ability to annually deduct mortgage interest from your taxes, owning a home also allows for the opportunity to build equity in your home. As you continue to make your monthly mortgage payments and as your home continues to rise in value, you are building equity in your home.
For a variety of reasons, there might come a time when you want to access the equity in your home, turning it into cash in your pocket. If that is an action you’d like to take, there are two primary options for you to consider – a home equity loan or a cash-out refinance.
In this article, we’d like to discuss the pros and cons of both.
Why Tap Your Home Equity?
At various times in life for a variety of reasons, people might find they are in need of some cash. Instead of applying for an expensive personal loan from a bank or using their high-interest credit cards, it is better for them (meaning it is more financially advantageous) to tap the equity in their home.
Typically, people use the equity in their homes for the following reasons:
- Home improvements
- College tuition
- To purchase a second home, vacation home or a rental property
- To pay-off higher-interest-rate debt, such as credit cards or auto loans
- Vacations or other luxuries
- Investments (acquisition of stocks, bonds, etc.)
- For some kind of emergency
Whatever your reasons for accessing the equity in your home, it is critical to know the differences between these two loan options so you can choose the one best suited to you.
Home Equity Loans
The main thing to know about a home equity loan is that it functions like a second mortgage on your home. It does not replace your existing home mortgage; it is simply a second loan that is made against the value of the available equity in your home.
It is a way to turn the equity in your home into cash, which you can use however you see fit.
There are 2 types of home equity debt – home equity loans and home equity lines of credit, also known as HELOCs.
Generally speaking, home equity loans and HELOCs have shorter repayment terms than a primary mortgage. For example, most first mortgages are structured to be repaid over 30 years. However, home equity loans and lines of credit typically have repayment periods of 15 years or less (though this term varies from lender to lender). It is important to keep this mind because the shorter the repayment term, the higher your monthly payment will be.
Also, a home equity loan really only makes sense if today’s interest rates are either the same as, or lower than, your current mortgage interest rate.
If you’re considering a home equity loan, your lender will determine how much equity exists in your home, and then determine how much they will lend against it. Your home’s equity will serve as collateral for the loan.
It is a loan with an agreed-upon, one-time, lump sum amount that is paid back over a set period of time, with a fixed-interest rate, and the same payment amount due each month.
Home Equity Line of Credit (HELOC)
A HELOC functions differently. It is more like a credit card because it has a revolving balance. You and your lender agree on the maximum amount you can borrow and what the terms for repayment will be. This amount is typically based on the value of equity in your home.
Once the line of credit is approved and in place, you can withdraw money as you need it. And as you pay off the principal, you can use the credit again.
Unlike a fixed rate home equity loan, a HELOC has a variable-interest rate that fluctuates over the life of the loan. It is also segmented into two distinct periods – a draw period and a repayment period.
During a HELOC’s draw period, you can borrow against it and are only obliged to make a minimum monthly payment, which can be interest-only, if you prefer.
However, during the repayment period, you can't add new debt and must repay the balance over the remaining life of the loan.
So, with a HELOC, your monthly payment will vary depending on the market interest rate, the amount you owe, and whether your credit line is in the draw period or the repayment period.
Another advantage to both home equity loans and HELOCs is that usually a borrower can get access to cash quickly. Lenders typically approve and fund home equity loans faster than they can refinance your mortgage. Also, like all mortgage loans, the interest on your home equity loan is likely to be tax deductible.
With both a home equity loan and a HELOC, the balance of your loan has to be paid off when you sell the house.
Cash Out Refinance
Just as a home equity loan or a home equity line of credit allows a borrower to turn their home equity into cash, so too does a cash out refinance. But the loan mechanism is substantially different.
A cash out refinance is a brand-new loan. It replaces your existing mortgage.
A cash-out refinance occurs when the borrower refinances their mortgage for more than the amount they currently owe, and they pocket the difference in cash.
Cash-out refinancing differs from a home equity loan in several ways:
- A home equity loan is a second loan on top of your first mortgage.
- A cash-out refinance is a replacement of your existing mortgage.
- The interest rates on a cash-out refinancing are usually lower than the interest rate on a home equity loan.
- You pay closing costs when you refinance your mortgage.
- You generally don't pay closing costs for a home equity loan.
- Closing costs can amount to hundreds, if not, thousands of dollars.
So, as you can see, each loan type has its distinct advantages. Generally, a home equity loan has a higher interest rate and a shorter term but there are no closing costs. While a cash out refinance has a lower interest rate and a longer term but closing costs have to be paid.
There are other considerations as well. It doesn’t make sense to do a cash out refinance if your new interest rate is higher than the interest rate on your current mortgage. It only makes sense if you are refinancing to a lower interest rate.
Also, if you are 20 years into a 30-year mortgage and every month you’re paying off more principal than interest, it probably doesn’t make sense to do a cash out refinance. If you need cash, a home equity loan would be a better choice.
It is necessary to analyze your specific situation and what you want to accomplish in order to know which loan vehicle is right for you.
Perhaps it would be helpful to provide an example:
A homeowner wishes to extract $100,000 dollars of equity out of his home:
Home value: $500,000
Amount owed: $300,000
Home equity: $200,000
The home is currently worth $500,000 and the homeowner has an existing mortgage balance of $300,000, so there is $200,000 in available home equity.
In this example, the homeowner wishes to extract $100,000 in cash from that equity, and he can either get a home equity loan, a HELOC, or execute a cash-out refinance.
Let’s assume the homeowner opts to add a second mortgage via a home equity loan:
Home value: $500,000
Existing liens: $300,000
Home equity loan: $100,000 (behind the 1st mortgage)
Home equity: $100,000
In the above example, the homeowner adds a second mortgage behind their existing $300,000 first mortgage. The $100,000 home equity loan increases their existing loan balance to $400,000, and subsequently lowers the equity in their home to $100,000.
But the homeowner now has a $100,000 in cash to use for however he wishes, without changing the rate or term of his existing first mortgage.
Now let’s assume he executes a cash-out refinance and adding cash-out:
Home value: $500,000
Existing liens: $300,000
Cash-out refinance: $400,000 (new 1st mortgage)
Home equity: $100,000
Cash to Borrower: $100,000
In this example, the homeowner refinances his original $300,000 mortgage and takes $100,000 cash out, creating a new $400,000 mortgage.
The homeowner still has a single loan, although a completely new mortgage with a new term and interest rate, more than likely from a different bank or mortgage lender.
So, which approach is best? The short answer is that it depends on your unique financial situation.
If interest rates are low at the time you’re looking to extract cash out of your home, you may want to refinance your existing mortgage into a new loan.
If mortgage rates aren’t favorable but you still need cash, it’s probably best to leave your first mortgage untouched and add a second mortgage behind it. That way the interest rate on your first mortgage remains intact.
As always, we encourage anyone who is thinking of obtaining a mortgage to seek advice from financial professionals who can analyze your personal situation and provide the best possible guidance for you.