Home equity vs. Refinance

Published January 26, 2022
Better
by Better

Two Semi Circles Inside Dark Green Box: One of Person On Phone Reviewing Document and One of a House


What You’ll Learn

What home equity is, how you earn it, and different options for tapping into 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’ve been consistently paying your mortgage and now you're starting to think about new financial goals—like home renovations, debt consolidation, or even putting money toward your child’s college tuition.

But if you’re diverting the majority of your cash flow to mortgage payments, it might not leave much left over to cover these other goals. Luckily, there’s a way to leverage your home itself and generate liquid assets (aka, cash)—this can be done by tapping into your home equity. Let's go over what equity is and how you can turn it into cash.



Home equity: what it is and how to earn it

Your home equity is the portion of your home that you own—you can calculate this by measuring the value of your home minus the amount of money you still owe on your mortgage. For example, if your home is worth $250,000 and your current loan balance is $150,000, then you have $100,000 in home equity:

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

There are a number of ways your home equity can grow. The first and most obvious way to grow your home equity is by making your monthly mortgage payments. Every time you make a mortgage payment and reduce the outstanding principal balance of your loan, you essentially “buy back” a portion of your home’s value from your mortgage lender.

Your equity can also increase 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 occur naturally over time 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 the difference is your earned home equity.

So, how do you turn equity into cash?

There are 3 main ways you can access your home’s equity: Taking out a home equity loan (HEL), opening a home equity line of credit (HELOC), or doing a cash-out refinance. Here’s what you need to know about each scenario, and how to decide which one is the best fit 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 once you finish paying it off, 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 “draw period.” After that, there is a 20-year repayment period when the credit line is no longer available and you’ll pay back the balance of the loan. You can also choose to 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

The interest rate you lock in for your home equity loan is fixed—meaning you can’t renegotiate down the line. HEL rates are typically higher than 30-year fixed-rate mortgage rates, but closing costs for these loans are substantially lower because there are fewer operational and processing costs and the loan amounts are smaller.

Home equity line of credit interest rates can fluctuate according to changes in the U.S. Prime Rate throughout the life of the loan. However, you’ll likely pay very little or even nothing in closing costs. Even with the fluctuating interest rate, it may still be more cost-effective to use a HELOC for major purchases than charging them to a credit card. 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 get a home equity loan, you’ll receive the loan disbursement in full as one lump sum, which is wired to a bank account of your choice. From there, you have the freedom to spend or save the money in any way you choose in whatever time frame you decide.

A home equity line of credit works differently. A line of credit 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 it’s drawn.

Tap into home equity with a cash-out refinance

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

Loan terms

With a cash-out refinance, you essentially take out a new mortgage greater than the balance of your existing loan, but less than your home’s market value. This allows you to pay off the remaining balance of your existing mortgage and “cash out” your additional home equity. The new loan will result in a new interest rate and loan term, along with a new repayment schedule—typically somewhere between 15 and 30 years depending on the loan you choose. Keep in mind that acash-out refinance may be subject to, prepayment penalties; while it’s not common, it depends on the lender and loan so make sure you factor that into the cost of your refi if applicable.

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, it might be cheaper overall to leverage your equity through a cash-out refinance. Making payments on a single loan may be substantially more manageable than making payments on your original mortgage plus the second mortgage (HEL or HELOC) combined. To compare the costs of both options, calculate how long it will take you to break even on your cash-out refinance. Also look at the monthly payment amounts to make sure you have the budget capacity to manage the extra debt.



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 “cash-out”) 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 the original example, 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

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.

Cash out refinance vs HELOC vs refinance

Although each of these 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. Take a look at the following breakdown of advantages and disadvantages to see how they might impact your decision:

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 costs go up over time
  • Easy access to cash may tempt you to overspend, if you’re not disciplined
  • Creates an additional payment on top of your monthly mortgage, and adds a 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 depending on the break-even point
  • 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 not allow you to take as much 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 it’s a small amount:

If you don’t need all your available home equity, or if you’d be tempted to overspend by a HELOC’s open access to funds, then a cash-out refinance or home equity loan (HEL) might be best. Comparing the costs, payment structure, and different break-even points between the two loans will tell you which is the smarter move.

When your plans are uncertain, and you want flexibility:

If you don’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. If you can snag a significantly lower interest rate, you might be able to offset the higher closing costs over the long term. Not only that, but by consolidating your original mortgage and your home equity withdrawal, you’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? Check your rates today.



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