Overview
When you own a home, you get the opportunity to build equity in that property. Every time you make a mortgage payment or your home increases in value, you gain more equity. And once you have enough equity… You can actually borrow from it and turn it into cash.
Many homeowners do this to pay for repairs or renovations, cover costs like medical bills or college tuition for their kids, or, in some cases, even pay off higher-interest debts like credit cards.
Whatever the reason for tapping your equity, you have three major tools you can use to do it: A home equity loan, a home equity line of credit (HELOC), or a cash-out refinance. Here’s how those differ and when one makes more sense than another.
What is a Home Equity Loan?
A home equity loan allows you to borrow from your home equity and get a lump-sum payment (at closing) in return. You can then use those funds toward whatever you wish.
Home equity loans come with fixed interest rates and payments spread across many years, usually anywhere from five to 20 years. They are second mortgages, which means they’re a loan you take out in addition to your main mortgage. (So you’ll need to make two separate loan payments every month moving forward).
Who home equity loans are best for:
These types of loans are usually best if you know how much you need and want a consistent, reliable rate and monthly payment for the long haul.
What is a HELOC?
A home equity line of credit, or HELOC, is similar to a home equity loan in that it is another type of second mortgage, meaning it adds a second monthly payment to your household. The big difference, though, is that unlike the lump sum that home equity loans offer, HELOCs come with a line of credit you can withdraw from over time.
In most cases, you can pull money from your HELOC line for up to 10 years, withdrawing and paying it back as needed. During this time, you’ll typically only pay interest on what you withdraw. Once that draw period ends, you enter repayment, which is when you’ll make full principal and interest payments to your lender. The repayment period is typically 20 years.
Another key difference is that HELOCs usually have variable interest rates, which means your rate can change over time. That often means a higher rate and payment years down the line.
Who HELOCs are best for:
HELOCs are typically best if you aren’t sure how much money you need or want extended access to cash for a long period (maybe to serve as a financial safety net, for example). They’re also good if you know your income is going to increase and you can handle a potential jump in rates later on.
What is a Cash-Out Refinance?
A cash-out refinance functions quite a bit differently from home equity loans and HELOCs. With this strategy, you’re not taking out a second loan. Instead, you’re replacing your current mortgage loan with a new one, one with a larger balance than your existing mortgage has.
Here’s how it works: You take out the larger loan, then use the funds to pay off your old mortgage balance. This essentially replaces your old loan with a new one, and you get the difference (between your new balance and old balance) back in cash. You can then spend that money however you’d like.
Cash-out refinances can come with fixed- or variable interest rates and up to 30-year terms. You’ll get your cash as a lump sum payment at closing, just like a home equity loan.
One thing to consider with a cash-out refinance is that it means a new rate and term for your main mortgage. If you’re one of the lucky homeowners who snagged a super-low interest rate during the pandemic, that could mean trading in a very low rate for one of today’s much higher ones.
Who cash-out refinances are best for:
Cash-out refinances are a good option if you know how much money you need and are comfortable replacing your existing mortgage loan, including its rate and payoff term, based on current market conditions. They’re also a good option if you don’t want to add a second monthly payment to your household.
Home Equity Loans vs. HELOCs vs. Cash-out Refinances
| Home equity loan | HELOC | Cash-out refinance | |
| Best if | You know how much cash you need You can handle a second monthly payment You want a consistent rate and payment schedule | You need extended access to cash You can handle a second monthly mortgage payment You can handle a rate and payment that can potentially increase over time | You know how much cash you need You’re comfortable replacing the terms of your current mortgage loan You want a long-term repayment schedule |
| How it works | Second mortgage Lump sum at closing | Second mortgage Line of credit you can withdraw from over time | Replaces current mortgage entirely Lump sum at closing |
| Interest rate type | Usually fixed | Usually variable | Either fixed or variable |
| Loan term | 5 to 20 years | 10-year draw period
| Up to 30 years |
Know the Risks
It’s important to note that all three of these options — home equity loans, HELOCs, and cash-out refinances — use your home as collateral. That means if you fail to make your payments, the lender could foreclose on your house.
For this reason, it’s critical that you never borrow against your home equity if you’re not absolutely sure you can make your payments.
If you’re not confident you can make payments, or you just don’t know the best tool to use for tapping your home equity, consider talking to a mortgage professional or financial advisor before moving forward. They can look at your finances and help you make the best decision for your goals and budget.
by your friends at The Daily Navigator
