If you need a chunk of change for a home improvement project, paying for your student’s college tuition, consolidating your own debt, or even paying for medical bills, you may be able to pull that money out of your house. This can be done either through a home equity loan or a cash-out refinance. Which is better? There are pros and cons to both.
What is Equity?
Your home equity is how much of your home you actually own. This is measured by taking the current market value of your home and subtracting the balance of your mortgage. For example, if your home is worth $350,000 and you still own $200,000, then your equity in the house is equal to $150,000. Your equity grows with every mortgage payment you make, but it can also grow when home prices rise, like in today’s hot housing market where prices jumped 19% in 2021. If your area saw that kind of growth, you earned 19% in equity without having to pay an extra cent!
Home Equity Loan
If you’d like to tap some of that equity to fund another of your financial goals, you can take out a home equity loan. This is a second mortgage tied to your property as collateral. That means that if for any reason you cannot make your mortgage payments and your home is sold in foreclosure, your first mortgage will get paid off first and any leftover money from the sale of your home by the lender will get paid towards the second mortgage. Because this puts your second lender in a riskier position, you will likely have to pay a higher interest rate than on your first home loan.
A home equity loan can be in one of two forms: a traditional, amortized loan or a home equity line of credit (HELOC.) A standard home equity loan provides for a fixed interest rate and predictable payments. The closing costs might be lower than on a cash-out refinance and most have repayment terms between 5 and 10 years. In most cases, you can borrow up to 90% of your home’s value. The downsides include slightly higher interest rates than on cash-out refinances and a second lien is added to your first mortgage lien.
A HELOC is more like an equity credit card. You receive a loan limit and can borrow up to that limit as needed. For example, if you are paying for college tuition, you do not have to take out the full loan amount at once but can pull out what you need as it comes due. That way you only pay interest on the funds you have drawn down. This flexible draw period can last up to 10 years, after which you cannot pull out any more money and you must start repaying the loan. One drawback, however, may be that the interest rate is usually variable and could go up over time with market fluctuations. And as with a traditional home equity loan, a HELOC places a second live on your property and requires you to be able to pay for your first mortgage and make additional payments on your second.
Cash-Out Refinance Loans
A cash-out refinance allows you to pay off your existing mortgage with a brand-new, larger mortgage. You get to pocket the difference between your old mortgage balance and the new loan total. That cash can be used for any purpose. These refinance loans typically have lower interest rates than home equity loans and HELOCs because they are still first mortgages, however the interest rate might be slightly higher than on a standard mortgage. It can also be nice to have just one mortgage payment to handle, instead of two, with just the single lien on your property. The cons might include higher closing costs than on a home equity loan, and you may not be able to borrow as much of your equity, usually up to 80%.
Benefits of a Cash-Out Refinance Loan
- Only one mortgage payment versus two
- First mortgages generally have lower rates than second mortgages
- Longer repayment terms usually mean lower monthly payments
These materials are not from HUD or FHA and were not approved by HUD or a government agency and in some cases a home equity or refinance loan might result in higher finance charges over the life of the loan.