For longtime homeowners, home equity can be a great way to use the value of your home to pay for things like home improvement, debt consolidation, or even tuition for a child.
A home equity loan or line of credit (HELOC) might be the first thing that comes to mind when looking for ways to turn some of your home equity into cash – after all, there is “home equity” in the name of these types of loans. But right now, experts say there is a better way for most people to capitalize on their home equity: refinancing through cash-out.
Regardless of when or how you use your home equity for extra cash, it is important to remember that you are essentially borrowing money on your home that will be used as collateral in this type of lending. This means that if you don’t pay back the amount you borrowed, you could lose your home.
Here’s what you need to know about home equity loans, and why a cash-out refinance might be a better choice now:
What is a Home Equity Line of Credit (HELOC)?
Home equity lines of credit (HELOCs) are revolving lines of credit, like credit cards. They are backed by your home and traditionally operate on a 30 year model with a 10 year draw period and a 20 year repayment period. You can spend up to your credit limit during the draw period and then have 20 years to pay off your amount (plus interest).
What is a Home Equity Loan?
Home loans work like traditional loans. You receive a lump sum upfront and then pay monthly payments to pay off your loan (plus interest). You can use the funds from your home loan for anything you want.
The average interest rate on a home equity line of credit is currently around 4.68%, and fixed rate home equity loans are well in the five range, depending on the loan period, according to Greg McBride, senior financial analyst at Bankrate.com.
What is a cash-out refinancing?
A mortgage refinance with payoff is when you pay off your mortgage by getting a new mortgage that is larger than the one you currently have. You will be paid the difference. At this point, you will have extra money and a new mortgage to repay over time, just like the original, according to the terms of the new loan.
If your home is worth $ 250,000 and you owe $ 100,000 on the mortgage, you have $ 150,000 in equity. With a payout refinance, you might get a new mortgage for $ 200,000 – $ 100,000 more than you owed on the original mortgage. Subtract $ 12,000 from the closing cost of the new mortgage and you would pocket $ 88,000.
Why home equity loans don’t make sense right now
Mortgage rates are currently lower than home loan or HELOC rates. So, you can potentially pull equity out of your home as well at the same time lower the interest rate on your regular monthly payments. Experts say this is a smart move because the amount of interest you save on a new mortgage – what you get on a refinance – is much less than a home equity loan or (HELOC).
“If your current mortgage rate is three and a half percent, you won’t be taking out a four and a half percent home equity line of credit if you can refinance your first mortgage instead and bring that rate down to maybe two and a half percent,” says McBride.
After falling below 3% in late 2020, mortgage rates are slowly rising again, but are still significantly lower than a year before the pandemic. At the beginning of March, the average 15-year fixed-rate mortgage rate – a good loan for many to refinance – was still below 3.5%. Compared to the average interest rate of 4% that this type of loan had in July 2019, this is still a very low interest rate.
Using McBride’s example of interest rates and the disbursement refinancing breakdown from above, you can see exactly how much you would save in interest if you did a disbursement refinance instead of taking out a home loan on top of your original mortgage:
|Rector||interest rate||Interest Paid|
|Home loan||$ 25,000||4.5%||$ 9,424.70|
|Original mortgage||$ 100,000||3.5%||$ 39,190.33|
All in all, in addition to the total of $ 125,000 in principal payments, you’d pay a total of $ 48,615.03 in interest by adding a home loan to your current mortgage. Now let’s say your home is worth $ 250,000 – $ 150,000 more than you own in the example above. Take the closing cost of refinancing a new mortgage $ 200,000 6%, or $ 12,000, and you’d still pocket $ 88,000.
|New mortgage borrowers||interest rate||Interest Paid|
|Cash-out refinancing||$ 200,000||2.5%||$ 40,044.12|
If you take the refinance via payoff route, you will save $ 8,570.91 in interest compared to a home loan on your current mortgage. And apart from the interest rate advantage that comes with a refinance, home equity loans and HELOCs are currently more difficult to qualify than a refinance, says McBride.
What You Should Know Before Refinancing
There are a few factors to consider before refinancing. Most importantly, you know that there are costs to refinancing, at least until you have recovered your loss. You are given a new mortgage to replace your old one and this comes with new closing costs – 3 to 6% of the total value of the new mortgage. Another point to keep in mind is the importance of keeping your refinancing as short as possible so as not to prolong the mortgage payment and associated interest.
You should have your credit history in check before attempting refinance. If your credit history has decreased since you took out your current mortgage, you may not be eligible for a refinance.
Basically, it makes sense to refinance when you get a new interest rate that is a whole percentage point lower than your current one, says Darrin Q. English, Quontic’s development loan officer. So switching from 3.5% to 2.5% would be a good move using this baseline.
Look at your “recovery time”. For example, if you refinance and save $ 100 per month and it costs $ 2,000 to refinance, in 20 months you will recover from that refinance and start saving.
“If you can recover from the cost of this refinancing within two years, then by all means [do it]“Says English. But if the cost of your refinance takes you outside of a biennium and “you don’t have the monthly savings to understand this, you probably want to stay,” says English.
Know your options: HELOC, home equity, or cash-out refinancing
While a cash-out refinance makes the most sense given the current interest rates, it is not the only option. Home equity loans and home equity lines (HELOCs) are common ways homeowners can use their home equity for things like home improvement, debt consolidation, or even a child’s college tuition.
|Cash-out refinancing||Home loan||HELOC|
|What is it||A new mortgage to replace your current mortgage||Traditional loan that uses your home as collateral||Revolving line of credit secured by your home|
|length||Like mortgage terms – usually 15 or 30 years||Vary depending on how large your loan is; usually 10-30 years||Traditionally, work on a 30 year model with a 20 year draw and 10 year repayment period|