Owning a home is more than just the American dream; it’s an investment in your future. Unless you have retirement savings, investments, or business interests of comparable proportions, a home is likely to be your most significant possession. For most Americans, this investment asset offers two financial benefits – saving rent money and building net worth. According to the latest Federal Reserve study on US family finances, the median net worth of homeowner households is at least 40 times higher than households that don’t own their homes (more than a third of the population). However, it can offer another financial benefit through home equity.
Your home equity is the value of your home you actually have a claim to. If you have bought your home with cash or have paid off all your mortgage, your home equity is the current market value of your home. But if you are still paying off your mortgage, you are not the only one who has a claim on your home; the bank does too. In this case, your home equity is its current market value minus the amount you have to pay toward the mortgage.
Let’s look at an example. Say you bought a home for $500,000 ten years ago and paid a down payment of 20%, i.e., $100,000. At that time, the market value of your home was $500,000, and you’ve already paid 20% of it, so that’s your equity. That’s part of your home’s value that you can claim.
Today, the value of your home has risen to $700,000, and you only have $200,000 remaining on your mortgage.
Home Equity = Market Value of Your Home – Remaining Mortgage
Home Equity = $700,000 – $200,000 = $500,000
You have a home equity of about $500,000. That’s part of your net worth, and you can use it, but not directly. Just like other investment assets like dividends, you can’t reclaim the underlying value without selling the asset back into the market.
What you can do is borrow money against it. A home equity loan is different from a personal loan because it uses your home equity as collateral and may allow you to borrow more than your income and credit score would let you. There are three main types of home equity loans, and we will discuss two of them in this article.
Cash-out refinancing is a way to take equity out of your home by refinancing your mortgage. When you refinance your home, you are basically taking out a new mortgage while completely paying off your first one. Cash-out refinancing allows you to take advantage of the difference that exists between how much you own (home equity) and how much you owe (new mortgage). You can’t take out all of the home equity you have built up, but many lenders would allow you to take out as much as 80% of your home equity.
Let’s say you have $500,000 in home equity and still need to pay off $200,000 in the mortgage. You refinance your home with the existing (or new) mortgage lender who is willing to let you leverage 70% of your equity. That’s $350,000. You need $200,000 to close your existing mortgage. That leaves you with $150,000 that you can “cash out,” hence the term cash-out refinancing.
With cash-out refinancing, you replace one mortgage with another, but you will still have a single debt toward your home. But it’s important to understand that cash-out refinancing is an entirely new mortgage loan with its own loan term (amortization) and interest rates.
- If interest rates are significantly lower than when you started your original mortgage, you may pay less interest (collectively).
- The cash sum can be diverted toward a significant expense like home improvement.
- You can switch a high-interest rate debt (credit card debt) with a low-interest rate debt (mortgage) spread out over a long period.
- You can choose between APR and fixed-rate loans.
- High-interest rates can inflate the overall cost of your mortgage.
- Closing costs can be high (between 3-5% of loan value).
- You are assessed as a new mortgage lender, so a good credit score and history are important.
A Home Equity Line of Credit (HELOC) is a revolving line of credit that gives you the right to borrow money against your home’s equity for a period of time, called the draw period. You can borrow up to 80 to 85% of the home equity you have simultaneously or in segments. During the draw period, you only have to pay interest on the amount you owe, which makes borrowing very affordable. Once the draw period is over, you are required to pay back the principal loan.
For example, if you have equity of $500,000 and a good credit score, a lender may allow you to borrow up to $425,000 in HELOC. If you have a HELOC draw period of ten years, you have the option to borrow according to the set limit of your Line of Credit. If it’s set at $50,000 a year, you can borrow $50,000 each year (until you reach your borrowing equity limit).
Unlike cash-out refinancing, HELOC is a separate loan that you have to pay back in addition to your mortgage.
- You can borrow as much or as little as you need.
- Gives you a financial safety net against unpredictable expenses for a long period of time.
- Interest rates are typically low.
- The cost of borrowing is minimal.
- Less stringent credit score requirement.
- It’s a second lien on your home.
- Fixed-rate HELOCs have limitations.
- It can significantly increase your overall monthly debt repayment (mortgage + HELOC repayments).
Cash-out Refinancing vs. HELOC: The Right Choice in 2023
Both cash-out refinancing and HELOC are good options, but they are not good options for everyone or every time. You need to consider your financial needs and the current market conditions (and some other factors) before you make a decision in favor of either loan.
Generally, the best time to refinance your home, whether you are going with the conventional option or cash-out, is when the interest rates are lower than when you took out your mortgage loan. The 30-year fixed-rate mortgage is currently averaging close to 2007-2008 highs. So if you bought your home anytime in the last ten years, there is a high chance that the current mortgage rate is higher, making a cash-out refinancing less than ideal. However, it can still be a good idea:
- If you want to use the money to pay off even more expensive debt.
- Or you have an expense for which you have to take out a loan anyway, and cash-out refinancing is your best option (loan-to-loan comparison) because of the rates you are getting, or it’s allowing you to spread the debt over a long period.
HELOC rates are also quite high, thanks to the underlying federal rates. With the right lender, you may get an introductory rate for a few months (Bank of America is offering it for six months) that’s slightly lower.
If you need to borrow a relatively small sum, HELOC might be a good idea right now. You can borrow the sum, pay off the interest rate only, and once the interest rates go down, start paying off the principal to close your HELOC early. But if you need a substantial enough sum, a cash-out refinancing might be a better idea. You may be strapped with a few years of high payments, but you may be able to refinance your home when the interest rates are low enough (without taking any more equity out).
The ideal choice will still be chiefly determined by your financial requirements.