The best way to tap home equity, now that the Fed’s cutting rates

Back in September, the Federal Reserve finally began to lower interest rates, and continued the cuts at its most recent November meeting. HELOC and home equity rates have fallen in response. In fact, borrowing against your home’s value hasn’t been this affordable in about a year.

People are paying attention. Mortgage holders collectively withdrew about $48 billion of their home equity in the third quarter of 2024 —  the largest sum in two years. “With recent interest rate cuts, homeowners may feel tempted to unlock their home’s equity to access capital,” says Tim Choate, founder and CEO of RedAwning.com, a platform for short-term vacation rental owners and property managers.

“Choosing between a home equity loan, HELOC or cash-out refinance isn’t a one-size-fits-all decision,” Choate adds. “Each option has unique characteristics that align with different financial needs, risk profiles, and flexibility requirements.”

Let’s explore those differences — and how to weigh home equity loans and HELOCs vs. cash-out refinances.

Ways to tap your home’s equity

There are three main ways to access your home equity and turn it into cash: home equity lines of credit (HELOCs), home equity loans, and cash-out refinance. All are home-secured debts — that is, they’re backed by an asset (namely, your residence). All can be good sources if you need significant sums — a five-figure loan, at least.

The cash-out refinance is essentially a mortgage with benefits: You’d replace your current mortgage with it. The other two are loans that you could take out in addition to your primary mortgage.

HELOCs: overview

A home equity line of credit (HELOC) is a revolving, open line of credit at your disposal, which functions much like a credit card — you can use it as needed, repaying and then borrowing again. However, a HELOC has some benefits over credit cards.

“Typically, the available balance you can spend on a HELOC is higher than a credit card, and the interest rates are lower than credit cards,” says Michael Foguth, president and founder of the Howell, Michigan-based Foguth Financial Group, “But a HELOC still has to go through underwriting like a typical mortgage because you’re using equity in [your] home to back up the loan.”

HELOCs generally have a variable interest rate and an initial draw period, which can last as long as 10 years. During that time, you can take out funds and make interest-only payments. Once the draw period ends, there’s a repayment period, during which interest and principal are repaid for 10 to 20 more years.

With a line of credit, however, it can be easy to get in over your head, using more money than you really need to use or are prepared to pay back. The changes in payment amounts can also be challenging to keep up with.

When should I choose a HELOC?

You draw at your own pace: HELOCs let you take out cash multiple times, on an as-needed basis. Home equity loans and cash-out refinancing only offer lump sums.

You can make a second payment each month: You can have a HELOC in addition to your current mortgage, so you’ll need to be able to afford an extra monthly bill.

You don’t mind a variable interest rate: The interest rate on HELOCs fluctuates, which means the rate could rise. Only consider a HELOC if you’re able to handle that.

“In a rate-cut environment, a HELOC can initially present lower monthly payments due to its variable nature, though borrowers should be mindful of potential rate hikes later,” says Choate. “For those with intermittent financial needs—say, a series of smaller renovations or periodic tuition payments—a HELOC is ideal, as it grants access to funds over time without the need to reapply.”

Home equity loans: overview

A home equity loan allows you to borrow funds in a lump sum. The loan is essentially a second mortgage: The money is repaid over a set period typically ranging from five to 30 years, at a fixed interest rate.

However, you typically end up paying a higher interest rate for a home equity loan than for a mortgage.“It has to be that way because the lender is taking more risk,” says Foguth. “The home equity loan takes a second position to your mortgage. If you default, the lender who holds your mortgage gets their money back before the lender who provided the home equity loan.”

When should I choose a home equity loan?

You want predictable monthly payments: As with your primary mortgage, the same amount is due each month, for the lifespan of the loan. “It’s particularly favorable for borrowers looking to avoid market fluctuations that could increase repayment costs over time,” says Choate. “With rates now more attractive, this option serves well for substantial one-time expenses like home renovations or debt consolidation.

You can afford a second mortgage payment each month: Taking out a home equity loan means you will be making two monthly home loan payments: one for your original mortgage and one for your new equity loan. Before you sign on the dotted line, crunch the numbers to be sure you can actually afford the additional payment.

You don’t want to change the terms of your mortgage: A home equity loan exists side-by-side with your mortgage, and doesn’t affect it in any way. Aside from using the same property as collateral, it’s a separate animal. In contrast, a cash-out refinance replaces your existing mortgage with a new one, resetting your mortgage term in the process, which might not be ideal for everyone.

Cash-out refinance: overview

A cash-out refinance is an entirely new loan that replaces your existing mortgage with a larger one. You receive the difference in a lump sum of cash when the new loan closes.

The cash-out refinance is essentially a mortgage with benefits: You’d replace your current mortgage with it. In contrast, home equity loans and HELOCs are debts in addition to your primary mortgage.

“This option is best suited for those looking to secure a single loan with a lower fixed rate than an existing mortgage, along with the added benefit of cash access,” says Choate. “With the recent rate cuts, homeowners who locked in higher rates years ago might benefit significantly from this option if they plan to stay in the home long-term.”

A major downside, however: If rates have increased since you took out your original mortgage, you could pay more interest over the life of the loan. In addition, if the equity in your home falls below 20 percent after doing the refinance, a lender might charge you  private mortgage insurance (PMI).

When should I choose a cash-out refinance?

You want to improve your mortgage terms: If interest rates have declined since you initiated your mortgage, a cash-out refinance could allow you to obtain a better rate. You can also extend or shorten the timespan of your mortgage.

You like to keep it simple: With a cash-out refinance, the mortgage payments and the loan payments are all in one —you’re repaying both simultaneously. HELOCs and home equity loans would be separate, additional payments to keep track of.

You need stability in your budget: With a HELOC, your monthly payments can vary substantially, particularly when you transition from interest-only payments during the draw period to the repayment period, when you must pay back the principal as well. A cash-out refinance offers long-term, fixed-rate financing, at a rate that’s lower than those of home equity loans.

“Cash-out refinances are particularly appealing now, as they often come with lower interest rates compared to home equity loans or HELOCs, and they consolidate debt into one payment,” says Chris Heller, president of Movoto Real Estate, an online real estate brokerage and listings platform. “However, higher closing costs and a potentially extended loan term are considerations.”

HELOC vs. home equity loan vs. cash-out refinance

Calculating how much equity you have in your home

Home equity is the portion of your home that you own outright. You can calculate home equity as either a number or a percentage of your home’s worth.

For example, if your outstanding mortgage balance is $150,000 and your home is valued at $450,000, you have $300,000 of equity.

To find your percentage of home equity, divide that dollar figure by the home’s value, then multiply by 100. In the above example, you’d have almost 67 percent equity in your home:

$300,000 ÷ $450,000 x 100 = 66.66%

Knowing both figures is useful. Most lenders require that you have a certain percentage of equity in your home before you can start tapping it. They also require that you maintain a portion of it untouched — at least 15 percent to 20 percent. That means that your loan’s balance must be no more than 80 percent to 85 percent of the home’s value. You can’t deplete your entire equity stake, in other words.

The dollar value of that equity also impacts what you can borrow. Two people, one owning a $500,000 home and the other owning a $1 million home, would be able to access very different amounts, even if they both had a 50 percent equity stake. There’s the dollar value of their equity — $250,000 and $500,000, respectively; there’s also the equity minimum a lender requires them to maintain. Assuming the lender requires 20 percent equity, the first homeowner could borrow up to $200,000; the second, up to $400,000.

Calculating combined loan-to-value (CLTV) ratio

One of the most important factors impacting your ability to obtain a home loan is what’s known as the combined loan-to-value (CLTV) ratio. Expressed as a percentage, the CLTV calculates how much debt is backed by a property vis-à-vis the property’s worth.

Lenders calculate the CLTV by adding up all the obligations (current and prospective) and dividing the total by the home’s current appraised value:

Amount owed on primary mortgage + second mortgage(s) ÷ appraised home value

Let’s say you owe $60,000 on your first mortgage and want to open a HELOC for up to $15,000. Your home is worth $400,000. The CLTV is 18.75 percent: ($60,000 + $15,000) ÷  $400,000 = 18.75

Lenders take the CLTV ratio into account when considering whether to approve your home equity loan application.

What are the tax implications of tapping your home’s equity?

Home equity loans, HELOCs and cash-out refis all bring you money, but they don’t incur taxes. They’re considered debt, not income.

In fact, like mortgages, they even carry some tax benefits. But only under certain conditions.

You can deduct the interest that you pay for home equity loans and HELOCs if the loan money goes towards “buying, building, or substantially improving” the home securing the debt. You must itemize deductions on your tax return (as opposed to taking the standard deduction).

There are also limitations on the amount of deductible interest. Joint and single filers can deduct interest on up to $750,000 of qualified loans, whereas married, filing separately taxpayers are capped at $375,000. Note these thresholds apply collectively to all your home-based debt. So if you have a mortgage and a home equity loan, the combined amount can’t exceed $750,000 for deductibility.

With a cash-out refinance, it gets a little more complicated. The interest on the portion of the loan that replaces your mortgage is tax-deductible, the way your old loan was. The cash-out portion could be deductible — if you use it on repairing or upgrading your home, as described above. But if you use it for anything else — debt repayment, emergency expenses, or business ventures — it’s not.

Final word on home equity loan/HELOC vs cash-out refinance

To sum up, which home equity product is best for you depends on a few factors: 

• how much equity you have
• how much money you need and when you need it
• your intended loan purpose
• your current mortgage’s interest rate
• the nature of the repayment terms

A home equity loan is ideal if interest rates are low, you want stable monthly payments and you know specifically how much you need to borrow. A HELOC can be a good option when interest rates are falling and if you’ll need funds over a long period or don’t have a precise sum in mind. However, be prepared for a jump in your payments if interest rates increase.  

A cash-out refinance is a bit different: It actually replaces your mortgage. It’s useful if you need cash right now and want to change your mortgage terms anyway. However, while it offers financing at a substantially lower interest rate than home equity loans and HELOCs, obtaining one will be a more elaborate, expensive process.

Whatever option you choose, remember that if you default on the loan, you could potentially lose your home. So having a repayment plan is essential.