One of the key advantages to homeownership is that your home isn’t just a place to live – it’s also an investment. Once you build up the equity in your home, you can borrow money against it to meet other needs – whether that’s to finance your child’s education, pay for a dream vacation, buy a car or boat, or possibly do some renovations.
When it comes time to tap into the value that’s accrued in your home for something you want or need, there are a few different options to consider – namely, cash-out refinances, home equity loans or home equity lines of credit (HELOCs).
While they all involve borrowing against your home’s equity, they each have their own unique characteristics and benefits. In this article, we’ll explore the differences between these three options so that you can make an informed decision about which one is right for you.
What Is a Cash-Out Refinance?
A cash-out refinance is when you refinance your existing mortgage for more than what you owe and take the difference between the two amounts in cash. Essentially, you’re replacing your existing mortgage with a new one that has a higher balance, and then using the extra funds to pay for other expenses.
For example, imagine that you currently owe $150,000 on your mortgage, but your home is actually worth $300,000. If you were to do a cash-out refinance for $200,000, you would use that new mortgage to pay off the old mortgage and receive $50,000 in cash. This cash can be used for things like remodeling your bath or kitchen, paying off high-interest debt or funding a major purchase – and you still only have one mortgage payment to make each month.
However, there is a drawback to this: Depending on what the interest rates were when you originally bought your home and what they are now, the interest rate on your new mortgage could be higher or lower than what you had before, and that can potentially cost or save you a significant amount of money over the long haul. That’s definitely something to consider before you decide to go that route – as well as the probability that your monthly mortgage payments will increase.
What Is a Home Equity Loan?
A home equity loan is a type of loan that allows you to borrow a chunk of money against the equity in your home. It’s referred to as a “second” mortgage because it’s a loan that’s secured by your property’s value.
For example, if you owe $150,000 on your mortgage and your home is worth $300,000, you have $150,000 in equity. With a home equity loan, if you need $50,000 of that equity for some reason, you can borrow just that $50,000 – without touching your original mortgage. You would then have two payments to make each month: your regular mortgage and the second mortgage.
Home equity loans often have lower interest rates than personal loans simply because they are secured by your home, and they may have looser credit requirements. That alone tends to make home equity loans popular when interest rates are high and lenders are being cautious, especially if you only want to use a modest amount of your home’s equity, know exactly how much you need and think that you can quickly repay it.
What Is a Home Equity Line of Credit (HELOC)?
A home equity line of credit (HELOC) is a bit different from either of the other two options because it creates a revolving credit line that allows you to borrow money against the equity in your home as you need it. Like a home equity loan, a HELOC is a second mortgage on your property.
With a HELOC, you’re essentially opening a secured credit line and you can use as little or as much of whatever limit you have whenever you choose. The best part of a HELOC, for many homeowners, is that you only pay interest on the amount that you’ve actually borrowed, not on the full amount of the line of credit.
The flexibility of a HELOC makes them ideal for people who want to use the money for ongoing renovations, to help finance their business or just want to have the security of knowing the money is available in an emergency.
However, keep in mind that HELOCs typically have variable interest rates, which means that your monthly payments can fluctuate over time. HELOC interest rates are usually based on the Prime interest rate. These rates adjust when the Fed increases or decreases the Federal Funds Rate.
Additionally, a HELOC makes the money so easy to use that it can be very tempting to draw more than you should, and some homeowners have found themselves in dire financial straits that way.
Which Option Is Right for You?
Deciding which option is right for you will depend on your individual financial situation and goals. Here are a few things to consider:
- How much money do you need to borrow? If you only need a small amount of money, a HELOC or home equity loan may be a better option than a cash-out refinance, which can involve higher closing costs or a raised interest rate.
- How important is predictability in your monthly payments? Some people don’t easily tolerate risk, and want a fixed monthly payment, so a home refi or a home equity loan may be better options than a HELOC.
- How long do you plan to stay in your home? If you plan to sell your home in the near future, a cash-out refinance may not make sense because you’ll have to pay back the full amount of the loan when you sell.
- How much equity do you have? If you don’t have much equity built up, a cash-out refinance may not be an option. However, you may still be able to qualify for a home equity loan or HELOC.
Ultimately, the best option for you will depend on your individual financial situation and goals. Before making a decision, be sure to do your research and speak with a financial advisor or mortgage lender to explore all of your options and find the one that’s right for you.