Andrew Dehan13-Minute Read
UPDATED: May 25, 2023
The key to tapping the monetary potential of your home is equity. Home equity is the difference between your home’s value and the remaining loan balance you have. If you have a fair amount of equity, you can convert that investment potential into dollars, which you can then use to finance a major purchase, investment or home improvement project.
You have several options for tapping your home’s equity: cash-out refinance, a home equity loan or a home equity line of credit (HELOC). This article will walk you through how each of these financing options work and how to decide which option is right for you.
Cash-out refinancing involves replacing the current first mortgage on your home with a new one. You’ll fill out a mortgage application, have your income and assets verified, and go through a credit check, among other requirements. Because you’re looking to tap equity, a property valuation will also be involved.
In a cash-out refinance, instead of writing a check to the lender at closing, you’ll receive a check from the lender. The amount of the check is dependent on how much equity you have in the home.
For the most part, lenders will follow the guidelines of one of several major mortgage investors when determining how much you qualify to take out.
When refinancing an FHA or conventional loan, you have to leave at least 20% equity in your home. So if you plan on doing a cash-out refi, you need to know how much your home is worth to determine whether the amount of equity you have will actually allow you to accomplish your goals after the refinance.
Say you’re looking into a cash-out refinance to help fund a renovation project that’s going to cost $40,000. Let’s assume the value of your home is $400,000. With a conventional or FHA loan, you’ll have to leave at least 20% equity in your home, which means the absolute most you could borrow is $320,000 (0.8 x 400,000).
Because $40,000 is 10% equity on a $400,000 home, you would need at least 30% existing equity. This puts your current mortgage balance at 280,000: 400,000 – (400,000*0.3).
The one exception to the rule that you have to leave 20% equity in your home is a VA cash-out refinance loan. With a minimum FICO® Score of 580, you must have at least 10% equity left in the home after taking cash out. You can also convert your full equity into cash in a cash-out refi if you have a FICO® Score of at least 620.
For VA jumbo loans, the median FICO® Score to take all cash out is 640 on loan amounts up to $1.5 million. On loan amounts up to $2 million, you can convert up to 90% of your equity into cash if you have a median credit score of 680. Because the VA doesn’t standardize credit requirements, other lenders may have different policies.
Of the options you have for accessing your home equity, a cash-out refinance is likely to offer the lowest interest rate. We’ll get into why a little later on.
A HELOC is a revolving line of credit tied to your home’s equity. This means it works a lot like a credit card, at least for the first part of the term. Let’s explain how this works.
HELOCs are divided into two periods: a draw period and a repayment period.
During the draw period, which might be the first 10 years on a 30-year HELOC, you can choose to draw up to the full amount of the line of credit you’re approved for, or you can elect to draw only a portion. Either way, you only pay interest on the amount that’s drawn.
You also have the option of putting funds back in to draw on in the future.
During the repayment period (20 years on a 30-year HELOC), the balance freezes and is fully amortized over the remainder of the term. Currently, you’ll begin to pay back the outstanding balance with principal and interest.
Although HELOCs tend to be cheaper to start than home equity loans, the interest rate is usually adjustable, which means it can fluctuate with the market.
On the plus side, this works best if you’re a homeowner who wants a resource but isn’t sure how much you might need in the future. You can use as much or as little as you need.
Rocket Mortgage doesn’t offer HELOCs.
Deciding which loan option is right for you can be a complex endeavor. However, we’ll go over several factors that should be considered when determining which option best fits your needs.
One of the biggest factors in determining which loan you should get is how much it’s going to cost you. When calculating the costs of your financing options, you should take into consideration mortgage interest rates, how much you intend to borrow, and your closing costs.
When considering cash-out refinancing against a home equity loan or HELOC, you’ll need to add up not only the interest rates, but the closing costs associated with each loan option.
And if you’re leaning toward a home equity loan or HELOC in addition to your primary mortgage, you’ll need to understand the concept of blended rates. For example, the rate on a home equity loan might be higher than it would be in a cash-out refinance, but the balance might also be smaller, so it changes the calculation.
Let’s say the current balance on your $400,000 house is $280,000. If you want to take out $40,000 – at an interest rate of 4% – your payment would be $1,527.73.
Now let’s look at what happens if you take out a home equity loan rather than replacing your existing mortgage with a cash-out refinance.
Let’s assume your current rate is 3.5% for a 30-year mortgage with $280,000 left on the balance. Meanwhile, you’re considering a $40,000 home equity loan at 6% interest. This is where the concept of blended interest rates – which are based on the amount of the balance being covered – will help you determine which financing option is most cost effective for you.
To figure out the combined interest rate, you multiply each rate by its portion of the balance and add the results together while dividing by the balance totals. Here’s what the math looks like:
280,000 * .035 = 9,800
40,000 * .06 = 2,400
12,200 (total interest) / 320,000 (total principal) = 0.0381 or 3.81% (blended interest rate)
In this scenario, the blended rate comes out to 3.81%. Assuming all other factors – such as closing costs – are equal, it would make more sense to keep your existing balance and do a home equity loan than to do a straight cash-out refinance to replace your original mortgage.
You can perform the same calculation with a HELOC and compare its blended rate to the rates of a cash-out refinance and a home equity loan. However, you should remember that the interest rate for HELOCs can change, so it might be best to calculate at the top end cap so that you have a clear picture of the worst-case scenario.
When you’re shopping for different loan options – whether it’s a cash-out refi, home equity loan or HELOC – you’ll see two different interest rates for the same loan option. The higher rate is the annual percentage rate (APR). This rate takes into account the full cost of the loan or line of credit because it includes closing costs.
You’ll also benefit from knowing that closing costs are generally higher the larger the difference is between the APR and the interest rate on the loan itself.
The other important step to take here is to make sure you’re comparing all factors on an equal basis. For example, if you’re looking at 30-year fixed conventional loans – or home equity loans or HELOCs – from one mortgage lender, make sure you’re looking at the same option with another.
In general, the higher the loan amount, the more it may make sense to do a cash-out refinance. The closing costs on a refinance assume a much lower percentage of the loan amount than they do on a home equity loan or HELOC.
Smaller loan amounts tend to favor HELOCs and home equity loans, but you should still compare estimates from different lenders and the blended rates on the different financing options.
Another benefit of cash-out refinances is that the interest rate tends to be lower than any of the other options. The reason for this is that a cash-out refinance replaces your current mortgage with a new one so that the refinance becomes your primary mortgage.
Home equity loans and HELOCs, on the other hand, are liens that have second position behind your current mortgage. Lien position has a big impact on interest rates because it can represent risk for the lender or mortgage investor.
Here’s how this works: If you run into financial trouble and end up defaulting on your home loans, your property is sold to try to make up any lost proceeds from the loan. In that scenario, the lender in first position is the priority. They get the money to pay off their loan, and the lender who did the second mortgage or HELOC gets what – if anything – is left over. That’s why rates for home equity loans or HELOCs tend to be higher.
Another key factor to consider is where you stand with your current mortgage. If you have a single mortgage and your interest rate is higher than the interest rates available for mortgages with similar terms, you’ll have a decent chance of saving money over time by doing a cash-out refinance, even if the loan amount is higher.
One important step with any loan is to calculate the breakeven point and figure out whether you plan on staying in the home long enough that you would actually start to make money on the deal.
For example, let’s say a lower interest rate saves you $50 per month in payments, but you pay $2,000 in closing costs. It would take you 40 months to break even on the deal. No matter what single loan option or combination you choose, it’s helpful to know whether you’re going to be in the home long enough for the cost to make sense.
If your financial situation has changed for the better, you may appear as less of a risk to lenders. As a result, you may be able to get better terms – including lower interest rates – on your refinance or home equity loan.
One of the key factors in determining your interest rate is your credit score. If yours has improved significantly, you might take a look at whether you can get better mortgage rates than you could before. When you’re doing a loan amount in the hundreds of thousands of dollars, a difference as small as a couple basis points may matter.
For example, on a $300,000 loan at an interest rate of 4%, the monthly payment would be $1,432.25, and you would pay a total of $215,608.59. If you change that interest rate to 3.75%, the monthly payment would become $1,389.35. You would also save more than $15,400 in interest.
And if you paid off a significant amount of debt since the last time you took out a mortgage, you may be able to access more equity. Your debt-to-income ratio (DTI) would be lower, which means you could afford a higher monthly payment than before.
Depending on what you’re using the loan for, special loan options may be available to you from your local, state or federal government.
For instance, if the mortgage is being used for home improvements related to making your home more energy efficient, you might look at the FHA’s Energy Efficient Mortgage program, which allows for the cost of these improvements to be built into the loan amount.
At this time, Rocket Mortgage doesn’t offer this loan option.
Now that we've gone over what you need to know from a cost and fit perspective, let’s take a look at the following FAQs regarding cash-out refinances, home equity loans and HELOCs.
Your home’s equity is determined by subtracting the balance remaining on your mortgage loan from your home’s overall value. This difference is often expressed as a percentage comparing the loan balance to the home value.
For example, if you put down $80,000 on a $400,000 home, you have 20% equity when you close on your home.
Assuming the value of your home stays constant, your equity increases each time you make a mortgage payment. Your home’s equity can also increase or decrease as your property value fluctuates.
The amount of money you make back for what you put into a renovation varies greatly based on several factors. However, it’s not always a dollar-for-dollar return.
According to the 2020 Cost Vs. Value report from Hanley Wood Media, the addition of a stone veneer façade tends to return 95.6% of its value nationwide. Meanwhile, an upscale primary bedroom suite returns only 51.6% of its value.
As with everything in real estate, your return on investment is as much about location as anything else. Some home renovations are more popular in certain areas than in others.
Prior to the 2017 Tax Cuts and Jobs Act, home equity loans had fully deductible interest regardless of the purpose for the home equity loan up to $100,000.
Now, the same limit exists, but with a caveat: In order to deduct interest on a home equity loan or HELOC, the proceeds of the loan have to be used to build, buy or improve your existing residence.
For example, you can deduct interest on a loan used to build an addition, but not one used to consolidate debt.
If you have any questions, it’s best to speak to a tax advisor.
Options for home equity loans and HELOCs may be different, but for cash-out refinances, you can take out up to 80% of your equity for conventional or FHA loans.
The reasoning for the need to leave 20% equity in your home is that lenders and mortgage investors don’t want to deal with private mortgage insurance (PMI) on conventional loans. This would push up monthly loan costs. When it comes to FHA, it’s strictly about risk management.
VA loans, however, allow you to take out the full amount of your equity if you have a FICO® Score of at least 620.
Because a cash-out refinance replaces your primary mortgage, you have all the options typically available to any mortgage borrower. This means you have the option to change your term (e.g., 15 years to 30 years, etc.) and go from a fixed rate to an adjustable-rate mortgage, or ARM.
Home equity loans and cash-out refinances have either fixed or adjustable rates. Adjustable-rate mortgages have a fixed-rate initial period for the first several years of the loan. After this period, the interest rates generally adjust once or twice a year based on market movement with the caveat that they can’t go above caps defined in the mortgage.
In contrast, HELOCs have variable interest rates that adjust daily based on the movement of the prime rate or another index like a treasury.
Existing equity in your home can be utilized in three primary ways.
A cash-out refinance involves refinancing your primary mortgage and taking out an entirely new loan. In order to do this, you generally need at least 20% equity to be left in your home.
A home equity loan is a second mortgage, which means you don’t have to touch your primary loan if you like your interest rate. The downside is that your primary mortgage lender has first position, so your interest rates tend to be higher because the lender on your primary mortgage gets paid first in the event of foreclosure or bankruptcy. Home equity loans come in fixed or adjustable rates.
HELOCs are also secondary to your primary mortgage, but they work like a credit card for the first part of the loan. Once the draw period is over, the balance freezes and repayment of full principal and interest begins.
Which option is right for you will depend on a number of factors, including the size of the loan; your financial situation; how long you plan to stay in your home; and what you plan to use the loan for.
If you’re ready to take a cash-out refinance out on your existing mortgage, you can get started with the preapproval process today.
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