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HOME EQUITY VS. REFINANCE
Published January 26, 2022
by Better
What You’ll Learn
What home equity is, how you earn it, and different options for tapping into it
The difference between home equity loans, home equity lines of credit, and
cash-out refinances
How to determine which home equity option is right for you
You worked hard, saved up, and bought your dream home. You’ve been consistently
paying your mortgage and now you're starting to think about new financial
goals—like home renovations, debt consolidation, or even putting money toward
your child’s college tuition.
But if you’re diverting the majority of your cash flow to mortgage payments, it
might not leave much left over to cover these other goals. Luckily, there’s a
way to leverage your home itself and generate liquid assets (aka, cash)—this can
be done by tapping into your home equity. Let's go over what equity is and how
you can turn it into cash.
Get Pre-Approved
HOME EQUITY: WHAT IT IS AND HOW TO EARN IT
Your home equity is the portion of your home that you own—you can calculate this
by measuring the value of your home minus the amount of money you still owe on
your mortgage. For example, if your home is worth $250,000 and your current loan
balance is $150,000, then you have $100,000 in home equity:
There are a number of ways your home equity can grow. The first and most obvious
way to grow your home equity is by making your monthly mortgage payments. Every
time you make a mortgage payment and reduce the outstanding principal balance of
your loan, you essentially “buy back” a portion of your home’s value from your
mortgage lender.
Your equity can also increase if the appraised value of your home goes up. The
easiest way to make this happen is through home improvements and renovations,
but it can also occur naturally over time housing appreciation and housing
market fluctuations. Whatever the reason, when the value of your home increases,
the difference between that value and your mortgage loan balance also gets
bigger, and the difference is your earned home equity.
SO, HOW DO YOU TURN EQUITY INTO CASH?
There are 3 main ways you can access your home’s equity: Taking out a home
equity loan (HEL), opening a home equity line of credit (HELOC), or doing a
cash-out refinance. Here’s what you need to know about each scenario, and how to
decide which one is the best fit for your financial situation.
TAPPING INTO YOUR HOME EQUITY WITH A HEL OR HELOC
Home equity loans and home equity lines of credit are both second mortgages that
use the equity in your home as collateral. However, there are some key
differences between them:
LOAN TERMS
A home equity loan is a second mortgage with a separate term and repayment
schedule from your existing mortgage. HELs typically offer repayment terms of 15
or 20 years. You can repay the balance early without penalty and once you finish
paying it off, the loan is closed.
A home equity line of credit is a second mortgage with a separate term and
repayment schedule from your existing first mortgage, but unlike HELs, HELOCs
allow you to draw cash as needed rather than in one lump sum. These cash draws
are available for the first 10 years of the loan, which is called the “draw
period.” After that, there is a 20-year repayment period when the credit line is
no longer available and you’ll pay back the balance of the loan. You can also
choose to repay any portion of the balance at any time without penalty and still
access the credit line within the draw period.
INTEREST RATES AND CLOSING COSTS
The interest rate you lock in for your home equity loan is fixed—meaning you
can’t renegotiate down the line. HEL rates are typically higher than 30-year
fixed-rate mortgage rates, but closing costs for these loans are substantially
lower because there are fewer operational and processing costs and the loan
amounts are smaller.
Home equity line of credit interest rates can fluctuate according to changes in
the U.S. Prime Rate throughout the life of the loan. However, you’ll likely pay
very little or even nothing in closing costs. Even with the fluctuating interest
rate, it may still be more cost-effective to use a HELOC for major purchases
than charging them to a credit card. Check HELOC terms carefully, as some
lenders offer the option to convert to a fixed-rate during the repayment period.
RECEIVING AND USING FUNDS
When you get a home equity loan, you’ll receive the loan disbursement in full as
one lump sum, which is wired to a bank account of your choice. From there, you
have the freedom to spend or save the money in any way you choose in whatever
time frame you decide.
A home equity line of credit works differently. A line of credit lets you
withdraw funds at any time and for any purpose during the 10-year draw period.
You may receive a checkbook or a debit card that gives you access to the credit
line. There are no restrictions on how or when you use the money once it’s
drawn.
TAP INTO HOME EQUITY WITH A CASH-OUT REFINANCE
If you’d rather not take out a second loan on your home, you can access your
home equity with a cash-out refinance. Here’s how it works:
LOAN TERMS
With a cash-out refinance, you essentially take out a new mortgage greater than
the balance of your existing loan, but less than your home’s market value. This
allows you to pay off the remaining balance of your existing mortgage and “cash
out” your additional home equity. The new loan will result in a new interest
rate and loan term, along with a new repayment schedule—typically somewhere
between 15 and 30 years depending on the loan you choose. Keep in mind that
acash-out refinance may be subject to, prepayment penalties; while it’s not
common, it depends on the lender and loan so make sure you factor that into the
cost of your refi if applicable.
INTEREST RATES AND CLOSING COSTS
Cash-out refinance loans may offer fixed or variable interest rates. While
closing costs are higher than both the HEL and HELOC options, it might be
cheaper overall to leverage your equity through a cash-out refinance. Making
payments on a single loan may be substantially more manageable than making
payments on your original mortgage plus the second mortgage (HEL or HELOC)
combined. To compare the costs of both options, calculate how long it will take
you to break even on your cash-out refinance. Also look at the monthly payment
amounts to make sure you have the budget capacity to manage the extra debt.
Get Pre-Approved
RECEIVING AND USING FUNDS
Similar to a home equity loan, a cash-out refinance offers you a lump sum at
closing. Your new loan pays off your existing first mortgage and then disburses
the difference in the remaining funds (the “cash-out”) as a check or into a bank
account of your choosing. You may spend or save loan proceeds in any way you
choose in whatever time frame you decide.
UNDERSTANDING HOW MUCH YOU CAN BORROW
Lenders will usually allow you to borrow up to 80% of your equity with a
cash-out refinance and between 80 to 90% of your equity with a HEL or HELOC.
So, using the same numbers from the original example, if your home is worth
$250,000 and you have an outstanding mortgage balance of $150,000, then you
could end up with around $62,500 if you took the maximum loan amount (85% of
total equity in this example):
This is a basic example for illustration purposes. Your final amount may be less
due to closing costs or any other expenses associated with each loan.
CASH OUT REFINANCE VS HELOC VS REFINANCE
Although each of these 3 options allow you to tap into the equity of your home,
their features and terms vary.
The best loan for you will depend on your needs and your financial
circumstances, but there are certainly pros and cons to each option. Take a look
at the following breakdown of advantages and disadvantages to see how they might
impact your decision:
HOME EQUITY LOAN
Pros:
* Fixed interest rate and predictable payments
* Closing costs may be lower than a cash-out refinance of your first mortgage
Cons:
* Loan is closed once paid, no reusable credit line
* Typically comes with higher rates than a cash-out refinance and higher
closing costs than a HELOC
* Additional payment on top of your monthly mortgage, and adds a lien to your
property behind your first mortgage lien
HOME EQUITY LINE OF CREDIT
Pros:
* Flexibility to use available credit as needed, and only pay interest on the
money you use
* May offer interest-only payments during the draw period
Cons:
* Variable interest rates could mean costs go up over time
* Easy access to cash may tempt you to overspend, if you’re not disciplined
* Creates an additional payment on top of your monthly mortgage, and adds a
lien
CASH-OUT REFINANCE
Pros:
* Usually the lowest interest rates compared to HELs or HELOCs
* If you plan to stay in your home for a while, may be more cost-effective over
time depending on the break-even point
* You will only have to make one mortgage payment
* Pays off and replaces existing first mortgage; assumes place as a new single
lien
Cons:
* Closing costs may be a bit higher
* Lenders may not allow you to take as much cash against your equity (~80% vs.
85-90% with a HEL or HELOC)
WHICH HOME EQUITY OPTION IS RIGHT FOR YOU?
Among HELs or HELOCs and cash-out refinances, you may find that one option
serves you better than the others. Here are a few scenarios to consider:
WHEN YOU KNOW EXACTLY HOW MUCH MONEY YOU NEED, AND IT’S A SMALL AMOUNT:
If you don’t need all your available home equity, or if you’d be tempted to
overspend by a HELOC’s open access to funds, then a cash-out refinance or home
equity loan (HEL) might be best. Comparing the costs, payment structure, and
different break-even points between the two loans will tell you which is the
smarter move.
WHEN YOUR PLANS ARE UNCERTAIN, AND YOU WANT FLEXIBILITY:
If you don’t know the specific dollar amount you will need or prefer to have
access to cash as you need it, then a HELOC may work best for you. While rates
are variable, they are substantially lower than credit cards, and may be
convertible to a fixed rate during the repayment period, depending upon the
lender.
WHEN YOU NEED A LARGE SUM AND PLAN TO STAY IN YOUR HOME FOR A WHILE:
In this scenario, a cash-out refinance could be the best option. If you can snag
a significantly lower interest rate, you might be able to offset the higher
closing costs over the long term. Not only that, but by consolidating your
original mortgage and your home equity withdrawal, you’ll only have to worry
about a single mortgage payment each month.
A cash-out refinance can be especially beneficial if mortgage rates have dropped
since you took out your original mortgage or refinanced previously. This can
lower your cost of borrowing and allow you to access cash from your home equity
at the same time. Win-win! Enter your details, a new interest rate, and loan
type in Better Mortgage's cash-out refinance calculator to see how much you can
cash out.
Want to get your personalized refinance rates and start planning your financial
future? Check your rates today.
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