Thanks to a hot housing market and skyrocketing home prices, homeowners gained an average of $63,600 in equity between the first quarter of 2021 and the first quarter of 2022. Meanwhile, interest rates have spiked as the Federal Reserve hiked the federal funds rate multiple times in an effort to lower inflation.
With mortgage rates now hovering around 5%, cash-out refinancing is a really bad idea since you would be giving up your the rate you have on your big mortgage. By contrast, HELOCs are a much better Idea as you can tap into your home equity gains without losing your original low mortgage rate.
HELOCs are affordable way to fund a host of projects, from home improvements to debt consolidation. Here’s what you should understand when weighing the merits of a HELOC vs. cash-out refi, and how both stack up against home equity loans.
Home equity lines of credit, or HELOCs, are revolving lines of credit that work much like credit cards secured by your home. They traditionally work on a 30-year model with a 10-year draw period and a 20-year repayment period. You can spend up to the credit limit of your line of credit during the draw period, and then you will have the repayment period to pay off whatever you spend (plus interest).
HELOCs, along with home equity loans, are commonly known as second mortgages because they don’t replace or alter your primary mortgage like a cash-out refinance does. Instead, you’ll have a separate loan in addition to your existing first mortgage, with an additional monthly payment aside from your mortgage payment.
HELOCs are variable-rate products, meaning your interest rate is determined by the prime rate plus a margin set by the lender. If the prime rate changes due to market conditions, so will your HELOC interest rate and monthly payment. Fixed-rate or rate-lock HELOCs do exist, but not all lenders offer this option.
A cash-out mortgage refinance is when you pay off your mortgage by getting a new one that’s larger than the one you currently have, and collect the difference as cash. You’ll then pay down your new mortgage as normal, according to the terms of the new loan.
For example, if your home is worth $250,000 and you owe $100,000 on the mortgage, you have $150,000 (60%) in equity. With a cash-out refinance, you might get a new mortgage for $200,000 — $100,000 more than you owe on the existing loan. You’ll then be able to receive that $100,000 as a lump sum cash payment — minus any closing costs — that you can spend however you wish. However, this will reduce the amount of equity you have in your home: from $150,000 (60%) to $50,000 (20%).
Keep in mind that a cash-out refinance will reset your loan term. If you’re 10 years into a 30-year mortgage and refinance to another 30-year mortgage, you’ll be back to year zero on your new mortgage.
HELOCs and cash-out refi loans differ in two ways: how they affect your primary mortgage, and how their interest rates and payments are structured.
Just like a rate and term refinance, a cash-out refinance replaces your primary mortgage with a new one that has new rates and terms. This can be detrimental if current refinance rates are higher than mortgage rates were when you first took out your mortgage, as it means your entire home loan — not just the extra cash you’re taking out — will have a higher interest rate. By contrast, a HELOC is a type of second mortgage, meaning it acts as a separate loan on top of your primary mortgage. This makes it a good way to tap into your home equity without altering your primary mortgage.
A cash-out refi is typically a fixed-rate mortgage that requires equal monthly payments over a repayment term that often lasts 15 to 30 years.
HELOCs’ variable interest rates fluctuate with the prime rate — something to bear in mind in today’s rising rate environment. HELOC rates will almost always remain lower than credit card rates (which are also variable), but they can be expected to keep rising along with market rates.
You must make HELOC payments each month, but during the draw period, the minimum payment required is often a relatively-low interest-only payment. You always have the option to pay more than the minimum, however, and it’s wise to do so if possible. Paying more can lower the amount of the principal-plus-interest payments you must make during the repayment period.
With some HELOCs, paying the required monthly minimum will not fully cover your balance. Unless you account for that discrepancy with extra payments, you’ll need to make a potentially large balloon payment at the end of the repayment period to satisfy your debt. As you enter the repayment period on a home equity line, it’s critical to understand that timing to avoid unpleasant surprises.
30-year term (10-year draw period, 20-year repayment period)
30 or 15 years
See the current HELOC rates
See the current cash-out refinance rates
Variable payments based on what you spent and the current (variable) interest rate
Fixed principal and interest payments according to a standard amortization schedule
Revolving credit line means you only pay interest on funds you use, not the entire line amount
Convenience of a credit card account at a far more affordable interest rate
During the draw period, you can make relatively low interest-only payments (or pay more if you wish)
Interest is tax-deductible if loan funds used for IRS-approved home improvements
Potential sudden shift to higher principal-plus-interest payments during repayment period (if using an interest-only HELOC)
Potential balloon payment can be challenging
Interest rates can be higher than on refinance loans
Fixed interest rate with stable monthly payment
If your original mortgage carries a high interest rate, you may be able to refinance at a lower rate
Only one monthly payment to manage
Interest paid on cash portion of the loan is tax deductible if used for IRS-approved home improvements
Refinancing could extend your payment period significantly if you’ve been paying your first mortgage for years
Current high interest rates mean you may pay a higher rate than on your original mortgage
May come with significant closing costs
Stretching payments on a cash loan over out over the life of a mortgage adds to total interest costs
The application process for both HELOCs and cash-out refis is similar to what you’ll encounter with traditional mortgage applications. You’ll need to show proof of your income and document your monthly debt spending. Lenders use this information to calculate your debt-to-income (DTI) ratio — the percentage of your monthly pre-tax income required to pay your debts.
You should also expect to document your home’s market value, so your lender can calculate how much equity you have in your home and determine how much cash you can borrow. In the case of a cash-out refinance, that could mean paying an appraiser of the lender’s choosing to evaluate the property. You may need an appraisal for a home equity line of credit as well, but if your home equity significantly exceeds the amount you want to borrow, it may not be necessary.
Lender requirements vary, but to qualify for a HELOC you’ll generally need:
Lender requirements for cash-out refinance also vary, but you’ll generally need:
A home equity loan is similar to a fixed-rate mortgage, or any other fixed-rate installment loan, such as a student loan or auto loan. With a home equity loan, you borrow a specific amount of cash at a set interest rate and pay it back in predictable monthly payments of equal size over a set number of years.
HELOCs are more like credit cards. The amount the lender authorizes you to borrow serves as a spending limit against which you can write checks or use a debit card to charge purchases. During the draw period, you can charge any amount up to the limit and repay some or all of the balance in payments of any size, as long as you meet a monthly minimum. Interest, charged at a variable rate that tracks the prime rate, only applies to outstanding balances.
When the HELOC draw period ends and the repayment period starts, you can no longer make charges and must repay all outstanding balances by the end of the repayment period.
Minimum HELOC payments during the draw period can be based on interest charges alone. During the repayment period, payments are based on outstanding principal and interest. Depending on the size of your balance, that can mean a significant increase in monthly payments.
A cash-out refinance loan replaces your existing mortgage loan with an entirely new loan. By contrast, a home equity loan places a second mortgage on your home. In practical terms, that means that a cash-out refinance will result in a larger monthly mortgage payment due to the larger principal balance (unless you can lower your interest rate enough to offset that difference) while a home equity loan results in a separate monthly loan payment while everything about your primary mortgage remains the same.
The interest rates on both cash-out refinances and home equity loans are higher than those on traditional home purchase mortgages, but home equity loan rates can be higher than those on cash-out refis. However, keep in mind that because a cash-out refinance replaces your current mortgage with a new one, it can still be more expensive in the long run if rates have risen since you first took out your mortgage and you must give up your old, lower mortgage rate.
The higher rates on home equity loans reflect the fact that if your home is foreclosed, your primary mortgage lender gets to recoup its losses before the issuer of a second mortgage. Second mortgage issuers charge more for taking on that risk, and often require higher credit scores than cash-out refi lenders for the same reason.
Popular during the past few years of low mortgage rates, cash-out refinancing allowed many homeowners to turn their home equity into cash while simultaneously securing a lower mortgage rate. This was a win-win for many borrowers, as it gave them access to increased cash flow while saving money on their primary mortgage.
Today, as mortgage interest rates surge, the chances of securing a lower mortgage interest rate have evaporated for many homeowners, and cash-out refis have lost much of their appeal. Instead, consumers are increasingly turning to HELOCs and home equity loans to tap into their record-high levels of home equity. These two products, both considered second mortgages, allow homeowners to borrow against their home equity without altering the rate or terms of their primary mortgage like cash-out refinancing does.
For example, let’s say you have a home worth $400,000 today. When you bought the home five years ago, you took out a 30-year mortgage of $320,000 with an interest rate of 3%. The principal and interest portion of your monthly mortgage payment is $1,349. If you’ve been paying your mortgage for five years according to a standard amortization schedule, you would now owe $283,871 on your mortgage and have $116,129 in home equity.
If you wanted to tap into your home equity for $50,000, you might have two options: a 30-year cash-out refinance at a 5% interest rate and a 30-year home equity loan at a 6% interest rate. Here’s how much your total monthly debt payments, and your total cost of borrowing over 30 years, would be with a home equity loan and a cash-out refinance:
If you took out a fixed-rate mortgage within the last few years, when rates were at historic lows, you’re unlikely to get a cash-out refi rate that beats your current rate or justifies the closing costs (roughly 3% to 6% of the loan amount) associated with a new mortgage.
While cash-out refinances are rapidly losing their advantages due to higher mortgage rates, they may still be a good fit for you if:
While cash-out refinances are rapidly losing their advantages due to higher mortgage rates, they may still be a good fit for you if:
If these circumstances apply to you, do the math and compare the monthly and long-term costs of a cash-out refinance vs. a HELOC or home equity loan on top of your current mortgage. It’s possible that a cash-out refi could still save you money.
If a second mortgage backed by home equity seems like the better option for you, you need to think about whether a HELOC or a home equity loan makes more sense.
A HELOC gives you the convenience of borrowing funds as needed against a spending limit, so it can be good for managing multiple or ongoing projects during the draw period. You can withdraw money as needed, repay the balance as you can, and then borrow against the limit for another use, while only incurring interest on the outstanding balance. On the other hand, a HELOC’s variable interest rate can make payments unpredictable, and the shift from relatively low interest-only minimum payments during the draw period to principal-plus-interest payments in the repayment period can pose budgeting challenges.
A conventional home equity loan, which provides a lump sum cash payment, can be great for covering major expenses. Also, its fixed interest rate and fixed monthly payments make it relatively easy to plan for. In inflationary times, however, it’s important to make sure the amount you borrow is adequate for your needs because you won’t be able to withdraw more money down the line without taking out a new loan.
Finally, as most experts predict we’re heading into a recession, you should also make sure you’re financially stable and able to keep up with both the loan payments and your primary mortgage before you take out any type of debt secured by your house. Only borrow what you need and can afford to pay off, and don’t take out a home equity loan, HELOC, or cash-out refinance for non-essential expenses like a vacation or wedding.
If these circumstances apply to you, do the math and compare the monthly and long-term costs of a cash-out refinance vs. a HELOC or home equity loan on top of your current mortgage. It’s possible that a cash-out refi could still save you money.
If a second mortgage backed by home equity seems like the better option for you, you need to think about whether a HELOC or a home equity loan makes more sense.
A HELOC gives you the convenience of borrowing funds as needed against a spending limit, so it can be good for managing multiple or ongoing projects during the draw period. You can withdraw money as needed, repay the balance as you can, and then borrow against the limit for another use, while only incurring interest on the outstanding balance. On the other hand, a HELOC’s variable interest rate can make payments unpredictable, and the shift from relatively low interest-only minimum payments during the draw period to principal-plus-interest payments in the repayment period can pose budgeting challenges.
A conventional home equity loan, which provides a lump sum cash payment, can be great for covering major expenses. Also, its fixed interest rate and fixed monthly payments make it relatively easy to plan for. In inflationary times, however, it’s important to make sure the amount you borrow is adequate for your needs because you won’t be able to withdraw more money down the line without taking out a new loan.
Finally, as most experts predict we’re heading into a recession, you should also make sure you’re financially stable and able to keep up with both the loan payments and your primary mortgage before you take out any type of debt secured by your house. Only borrow what you need and can afford to pay off, and don’t take out a home equity loan, HELOC, or cash-out refinance for non-essential expenses like a vacation or wedding.
