Home equity vs. Refinance

Better.com
Byย Better.com

Animated Home Against White Background Filling Up with Green "Equity" and Once Full, Cash Comes Out of the Top Representing a Customer Refinance


What Youโ€™ll Learn

What home equity is and how you earn 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're steadily paying your mortgage, and now you're starting to think about new financial goalsโ€”like home renovations, debt consolidation, or even paying for a childโ€™s college tuition.

If itโ€™s extra liquidity you need, then your home itself can be a great source of additional cash. It's all about tapping into your equity. Let's go over what equity is and how you can turn it into cash with a second mortgage or a cash-out refinance.

Home equity: what it is and how to earn it

Your home equity is the value of your home minus the amount of money you owe on your mortgage. For example, if your home is worth $250,000 and your loan balance is $150,000, then youโ€™re left with $100,000 in home equity:

Chart with Equation and Example Figures: Estimated Home Value - Outstanding Mortgage Balance = Home Equity

There are a number of ways your home equity can grow, starting with your monthly mortgage payments, which decrease the outstanding principal balance of your loan. Every time you make a mortgage payment, you essentially โ€œbuy backโ€ a portion of your homeโ€™s value from your mortgage lender.

Another way your home equity can increase is 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 happen through 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 that increase is your earned home equity.

So, how do you turn equity into cash?

There are 3 main ways you can access your homeโ€™s equity: Taking out a home equity loan (HEL), opening a home equity line of credit (HELOC), or doing a cash-out refinance. Hereโ€™s what you need to know about each scenario, and how to decide which one is the most suitable 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, upon payoff, 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 โ€œdraw period.โ€ After that, there is a 20-year repayment period when the credit line is no longer available and the balance is repaid. However, you may 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

Home equity loan interest rates are determined at the time you obtain the loan and are fixed for the life of the loan. HEL rates are typically higher than 30-year fixed-rate mortgage rates, but loan closing costs for these loans are substantially lower due to fewer operational and processing costs and lower loan amounts.

Home equity line of credit interest rates vary according to changes in the U.S. Prime Rate throughout the life of the loan. However, youโ€™ll likely pay little or even nothing in closing costs. While your interest rate may fluctuate, it may be more cost-effective to use a HELOC for major purchases than using credit cards. 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 choose a home equity loan, the money is given to you (disbursed) in full as one lump sum, which is wired to a bank account of your choosing. You may spend or save loan proceeds in any way you choose in whatever time frame you decide.

Conversely, a home equity line of credit is a line of credit that 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 drawn.

Tap into home equity with a cash-out refinance

If youโ€™d rather not take out a second loan on your home, you can access your home equity with a cash-out refinance. Hereโ€™s how it works:

Loan terms

With a cash-out refinance, you essentially take out a new mortgage greater than your existing loan balance but less than your homeโ€™s market value. This allows you to pay off your existing mortgage and โ€œcash outโ€ your additional home equity. The new loan will result in a new interest rate and loan term, along with a new repayment schedule, which, depending upon the loan you choose, will generally be between 15 and 30 years. With a cash-out refinance, prepayment penalties arenโ€™t common, although, these depend on the lender and loan.

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, if you have enough equity to take all the cash you need with a new first mortgage, then the loan payment may be substantially lower compared to making payments on both a first and second mortgage combined.

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 โ€œcash-outโ€) 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.

Step 1 and Step 2 on How to Calculate Maximum Amount of Equity That Could Be Borrowed, and Total Amount You Can Borrow

So, using the same numbers from earlier, 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):

$250,000 x .85 = $212,500 and $212,500 - 150,000 = $62,500

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.

Comparing a HEL, HELOC, and cash-out refinance

Although the 3 options allow you to tap into the equity of your home, their features and terms vary.

Chart with Green Checks Showing the Benefits that Come with a Home Equity Loan, HELOC, and Cash-Out Refinance

The best loan for you will depend on your needs and your financial circumstances, but there are certainly pros and cons to each option. Weโ€™ve laid them out here:

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 rising payments
  • Easy access to cash may tempt you to overspend, if youโ€™re not disciplined
  • Additional payment on top of your monthly mortgage, and adds a lien to your property behind your first mortgage 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
  • 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 allow you to take less 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 itโ€™s a small amount:

If you donโ€™t need all your available home equity, or if youโ€™d be tempted to overspend by a HELOCโ€™s open access to funds, then either a cash-out refinance or home equity loan (HEL) might be best. Comparing the costs, payment, and break-even differences between the two loans will tell you which is the smarter move.

When your plans are uncertain, and you want flexibility:

If you donโ€™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 because the lower interest rate would be more important than higher closing costs over the long term. Not only that, but by consolidating your original mortgage and your home equity withdrawal, youโ€™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!

Want to get your personalized refinance rates and start planning your financial future? Pre-approval with Better Mortgage only takes a few minutes and doesnโ€™t require a hard credit check.



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