Home equity loan or HELOC vs. cash-out mortgage refinance

You can tap your home’s equity for cash in various ways. The most popular fall into two categories: home-secured loans, including a lump-sum home equity loan or a home equity line of credit (HELOC), and a type of mortgage called a cash-out refinance.

Because your home is used as collateral in all of them, financing is less risky for a lender. As a result, you might receive a lower interest rate than an unsecured form of debt, like a credit card. On the downside, if you default on your payments, a lender can foreclose on your home.

Home equity loans, home equity lines of credit and cash-out refinances have varying features as well as their own pros and cons. Deciding which type of home equity product is best for you depends on:

• 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

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.

To find the dollar value of your home equity, subtract your home’s value from the remaining balance of your mortgage and any other loans secured by your home. For example, if your outstanding mortgage balance is $150,000 and your home is valued at $250,000, you have $100,000 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 40 percent  equity in your home:

Knowing both numbers 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 — 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.

HELOC/home equity loan vs cash-out refinance

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 additional 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.“Choose a HELOC when you prefer the flexibility to withdraw funds as needed,” says Matt Dunbar, senior vice president of the southeast region for Churchill Mortgage.

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. “The flexibility to borrow as needed is a key benefit, but the potential for rising payments due to interest rate fluctuations is a risk,” notes Dunbar. Only consider a HELOC if you’re able to handle that.

“HELOCs provide a flexible credit line with variable interest rates, secured by your home’s equity, suitable for ongoing financial needs or projects that have variable cost — for example, during a long-term home improvement project that will occur in phases,” says Dunbar. “Individuals with significant equity in their homes, who anticipate needing to access funds over time, find HELOCs particularly attractive.”

Home equity loans: overview

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

“A home equity loan provides a fixed amount of money at a fixed interest rate based on the equity of your home, making it an excellent choice for large, one-off expenses such as substantial home improvements,” explains Dunbar. “The certainty of fixed monthly payments is an advantage, though the potential for foreclosure if payments aren’t made and upfront costs are downsides.”

However, you typically end up paying a higher interest rate for a home equity loan than for a cash-out refinance.

“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.

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.

“People with stable incomes, good credit scores and substantial home equity are well-matched for this type of loan. Opt for a home equity loan over alternatives when you need a specific amount of money upfront for significant expenses, like an extensive renovation that requires a one-time payment,” recommends Dunbar.

Cash-out refinancing: 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.

This option appeals to homeowners who want to refinance and obtain some ready money at the same time.

“Cash-out refinancing allows you to refinance your mortgage for more than you owe and take the difference in cash, which can be appealing for accessing large amounts of money while potentially lowering your interest rate,” notes Dunbar. “The drawbacks include the possibility of higher long-term costs due to extending the loan term and the closing costs associated with refinancing. This option suits homeowners looking to lower their interest rate while simultaneously needing cash for big projects or to consolidate higher-interest debt.”

A major downside, however: If mortgage 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.

“A cash-out refi is a strategic choice if you’re planning significant home updates and can obtain a more favorable mortgage rate, merging financial efficiency with project funding,” Dunbar says.

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:

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 $100,000. The CLTV is 75 percent: ($60,000 + $15,000) ÷  $100,000 = 0.75

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

Deciding how to use your home equity? Let’s review:

A home equity loan provides all funds upfront, and you must repay the loan with a fixed interest rate. This might be a good option if interest rates are low and you know specifically how much you need to borrow.

A HELOC works like a credit card, allowing you to pull funds when you need them and pay them back after the draw period ends. HELOCs have variable interest rates, but some home equity lenders allow you to lock in a rate on some or all of your balance for a fee. HELOCs can be excellent options if you’ll need funds over a long period, or don’t have a precise sum in mind.

A cash-out refinance replaces your mortgage. It’s a good option for homeowners who need cash right now, but are also thinking about swapping out their current mortgage for a different term or a better interest rate.

Since it’s replacing your mortgage, a cash-out refinance is basically a bigger deal than the other two options. It might make it easier to borrow a larger sum, and it offers financing at a substantially lower interest rate than home equity loans and HELOCs. But it’ll be a more elaborate, expensive process.

Taking out any kind of loan against your home is a big decision. Whatever option you choose, keep in mind that if you default on the loan, a lender can foreclose.

Additional reporting by Erik Martin