Home Equity Loan Vs. Refinance Vs. HELOC: Which Is Right For You?
Kevin Graham13-Minute Read
November 16, 2020
Home can be as much about the investment potential as it is about the roof over your head and having a place of your own. Indeed, a home represents the largest financial transaction many of us will ever deal with. Therefore, you should consider it as big a part of your portfolio as you would your 401(k) or brokerage accounts and any mutual funds.
The key to tapping the monetary potential of your home is equity. There are several options for tapping that equity and you may find yourself considering the relative merits of a home equity loan versus a refinance and even comparing them to a home equity line of credit (HELOC). This article will walk you through how these work and how to decide which option is right for you.
Defining Your Financing Choices
Home equity is the difference between your home’s value and the remaining loan balance you have. This 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. It’s worth noting that equity can increase or decrease as your property value fluctuates. If the value is increasing, you’ll gain equity and vice versa.
If you have a fair amount of equity, you can convert that investment potential into dollars and put it to work for you to finance a major purchase, investment or home improvement project.
A cash-out refinance 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, there’s also going to be a property valuation involved.
In a cash-out refinance, instead of writing a check to the lender at closing, you get a check from the lender. The amount of the check is dependent on how much equity you have in the home. In determining how much you qualify to take out, for the most part, lenders follow the guidelines of one of several major mortgage investors.
When it comes to FHA and conventional loans, 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.
Let’s do some math to show you an example. 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 same $400,000 home value. No matter what, 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 theoretically 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 in a cash-out refinance is VA loans. You can convert your full equity into cash in a cash-out refi.
Rocket Mortgage® clients can do this with a median FICO® Score of 680 or higher for loans under the local conforming loan limit. For VA jumbo loans, the median FICO® Score to take all cash out is 740. 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.
Home Equity Loan
A home equity loan is also known as a second mortgage. You qualify and get a lump sum payment from a lender. Every month, you have two mortgage payments, one for the primary mortgage and one for a second mortgage. Like other mortgages, they can come with fixed or adjustable rates.
A common alternative to a home equity loan is a personal loan. While a home equity loan uses your home as collateral, a personal loan is unsecured. This means you don’t lose anything if you default, although this would be a major negative mark on your credit record.
In contrast, you can get a lower rate on a home equity loan because your home as collateral. The relative risk of a personal loan is much higher for a lender, so the interest rate will be higher to reflect that. Although the interest rate is much lower on a home equity loan, the risk shifts to the client because if you don’t make the payment, you can lose your home.
Rocket Mortgage® doesn’t offer home equity loans at this time.
Home Equity Line Of Credit (HELOC)
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 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.
Finally, during the repayment period (20 years on a 30-year HELOC) the balance freezes and is fully amortized over the remainder of the term so that you pay back in the outstanding balance payments with principal and interest.
Although HELOCs tend to be cheaper to start than home equity loans, the rate tends to be adjustable meaning the downside is that it can fluctuate with the market. On the plus side, this works best for homeowners who want a resource, but aren’t sure how much they might need in the future. You can use as much or as little as you need.
Rocket Mortgage® doesn’t offer HELOCs.
How To Compare Your Options
Deciding which loan option is right for you can be a complex endeavor with many factors. However, we’ll go over several considerations that should be factored into which option best fits your needs.
How Much Will Each Loan Cost?
One of the biggest factors in determining what one you should get is how much it’s going to cost you. Unfortunately, this is where things get a bit tricky because it’s all dependent not only on rates, but also on how much you intend to borrow, and the closing costs associated with that.
Do The Math
The important thing to be able to tell which option is right for you is to start by doing the math. Consider not only interest rates but the closing costs associated with any loan options as well. Add it all up.
When considering a home equity loan or HELOC in addition to a primary mortgage, it’s important to understand the concept of blended rates so that you can compare apples to apples. 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 go back to our $400,000 house. Let’s say the current balance is $280,000. If you want to take out $40,000 and the interest rate is 4%, your payment is $1,527.73. Now let’s look at what happens if we take out a home equity loan rather than touching our existing mortgage.
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 blended interest rates based on the amount of the balance being covered come into play.
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, so the formula looks like this
When you work that out, the blended rate becomes 3.81%, so in this case, it makes more sense to keep your existing balance and do a home equity loan than to do a straight cash-out refinance. Remember, this is assuming all is held equal with things like closing costs.
You can do the same math with a HELOC and do a comparison, although I would caution you to remember that the interest rate 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 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. One will be lower than the other. The higher rate is the annual percentage rate (APR). This takes into account the full cost of the loan or line of credit because it includes closing costs.
Another trick you can employ to help you compare closing costs is the fact that generally, the bigger the difference between the APR and the interest rate on the loan itself, the higher the closing costs.
The other important thing to do here is to make sure you’re comparing things on an equal basis. That means if you’re looking at 30-year fixed conventional loans at one lender, make sure you’re looking at the same option with another. Do the same thing for home equity loans and HELOCs.
The Amount Matters
In general, the higher the loan amount, the more it may make sense to do a cash-out refinance. This is because the closing costs are much lower as a percentage of the loan amount than they would be on a home equity loan or HELOC. On the other hand, smaller loan amounts tend to favor HELOCs and home equity loans, but we would encourage you to get estimates and look at the math.
The other really nice thing about 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 is based on your primary mortgage and the other two have second position. Lien position has a big impact on interest rates because it can represent more or less 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 gets the money to pay off their loan, and the lender who did the second mortgage or HELOC gets what’s left over if anything. That’s why rates for home equity loans or HELOCs tend to be higher.
Your Current Interest Rate Vs. Today’s Rates
Another key thing 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, there’s a decent chance you’ll save money over time by doing a cash-out refinance, even if the loan amount is higher.
How Long Do You Plan To Stay In Your Home?
One of the things that’s important to do with any loan is to calculate the breakeven point and figure out whether you plan on staying in the home long enough where you actually start to make money on the deal.
As an example, let’s say a lower interest rate saves you $50 per month in payments, but as part of that, 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.
There are a couple of corollaries to this that we would be remiss if we didn’t mention. Let’s run through them briefly.
The first is that if you’re taking out equity to make an investment, those potential returns should be included in your breakeven calculations. Unless it’s something with a guaranteed interest rate, you probably want to calculate based on a scenario somewhere in the middle of the projections.
If you’re doing a home improvement, some of this goes beyond numbers and there may be other things at play. If your furnace is nearing the end of its life, the cost may be immaterial in comparison to turning into a popsicle. Or maybe the idea of turning your bathroom into a spa-like sanctuary will add to your relaxation in ways that can’t be measured.
Has Your Financial Situation Changed?
The business of lending is all about assessing risks and charging accordingly for the level of risk being taken on. This means that you may be able to get better terms including lower rates if your financial situation has changed for the better.
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 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.
To get an idea of how this works, let’s show this math. On a $300,000 loan at an interest rate of 4%, the monthly payment is $1,432.25 and you pay a total of $215,608.59. If you change that interest rate to 3.75%, the monthly payment becomes $1,389.35. You also save more than $15,400 in interest.
Another thing to keep in mind is that 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 than you otherwise might because a lower debt-to-income ratio (DTI) means that you can afford a higher monthly payment than you could before.
What Are You Using The Loan For?
Depending on what you’re using the loan for, there may be special loan options 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.
If I Use The Money For Home Improvements, Will I Get It Back When I Sell My Home?
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, this is as much about location, location, location as anything else. Some home renovations are more popular in certain areas than in others.
Can I Deduct The Interest I Pay On My Home Equity Loan From My Taxes?
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. As an 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, speak to a tax advisor.
How Much Equity Can I Take Out Of My Home?
Options for home equity loans and HELOCs may be different, but for cash-out refinances, you can take a up to 80% of your equity for conventional or FHA loans. The exception to this is VA loans where you can take out the full amount of your equity.
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.
Can I Change My Loan Term If I Do A Cash-Out Refinance?
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 ARM.
Do Home Equity Loans, Refinances, And HELOCs Come With Fixed Or Variable Interest Rates?
Home equity loans and cash-out refinances have either fixed or adjustable rates. Adjustable rate mortgages have a fixed-rate teaser period for the first several years of the loan before adjusting generally once per year after that based on market movement with the caveat that they can’t go above caps set in the loan agreement.
In contrast, HELOCs have variable interest rates that adjust daily based on the movement of the prime rate or another index like a treasury.
Summary: Tap Your Home Equity
There are three primary ways to utilize the existing equity in your home. 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, so that you don’t have to touch your primary loan if you like your interest rate. The downside is that because your primary mortgage lender has first position, interest rates tend to be higher because the lender on your primary mortgage gets paid first. 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 the size of the loan as well as your situation among other factors. Think about how long you plan to stay in your home and what you plan to use the loan for.
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