Understanding the differences between a home-equity line of credit and cash-out refinance is important if you want to make the most out of the value of your home. Buying a house is typically the biggest, most life-changing decision that many Americans will ever make. With the median price for a house in the U.S. hovering around $200,000 it’s certainly easy to see why this is such a huge decision. This is especially true when considering that mortgage terms often last multiple decades. Despite the huge price tag, houses are considered illiquid assets. This means that, by definition, you must sell your home to access the cash value of the equity you have built.
Because of this illiquid status, mortgage lenders and financial institutions let homeowners tap into the equity of their homes by means of a cash-out refinance or a home-equity line of credit. Both of these options will give you access to the cash value of your home’s equity, but what is the difference between the two? More importantly, which one is right for your situation?
Home-Equity Line of Credit or Cash-Out Refinance?
Why Homeowners Refinance
The three most common reasons for a homeowner to refinance their mortgage are: To lower interest rates, to lower their monthly payments (though these two don’t always coincide), and the third reason being to access liquid funds via the equity in their home. Let’s say, for example, you own a home that is worth $200,000 and owe $100,000 on the mortgage for that home. Your credit score likely has gone up, and mortgage interest rates could have potentially gone down. You can refinance that $100,000 for a lower interest rate to save money in the long haul.
When refinancing, depending on the equity in your home, you can also give yourself access to liquid funds for essentially anything. Whether you want to refinance other debt you may have, need to repair your home, want to put your triplets through college, or just want to take an extravagant vacation, the reasoning usually doesn’t matter. Usually is the caveat here, and you’ll see why later on in the article.
A cash-out refinance allows you to essentially “trade in” your mortgage for a new one that covers your current mortgage balance in addition to the amount of cash you need (or want) to take out from the equity in your home. Using the same example as above with a $200,000 home and a $100,000 mortgage balance, let’s say the homeowner needs access to $50,000 cash. Their new mortgage balance would be $150,000. It’s possible the monthly payments would be lower due to potentially lower interest rates and/or the terms of the payments being extended. You may only have 10 years left on your mortgage but for the refinance decide to extend the loan out under new terms for 15 or 20 years. Of course, longer payment terms mean more money is paid in interest over time.
Is a cash-out refinance a good choice? That depends entirely on your situation and what the money is needed for. There are many instances when taking cash out through refinancing is a much smarter decision than getting a home-equity line of credit.
- Debt Consolidation: A common reason for cash-out refinances is to consolidate debt. Let’s say you owe $50,000 on student loans, medical bills, and high-interest credit cards. The monthly payments are killing you and there is no end in sight. Taking advantage of a cash-out refinance is one of the smartest routes to take. This will consolidate everything into a lower monthly payment, with a lower interest rate, and give you some breathing room.
- Poor Money Management: If you have trouble with revolving debt (ex: credit cards) then you should probably consider going with a cash-out refinance over a home-equity line of credit. Having access to a revolving line of credit with such a high limit, often 5-6 figures, can be trouble for those who are impulsive with spending money.
- The Lender’s Terms Say So: Sometimes a lender or financial institution will approve giving you access to the equity in your home, but they want to dictate where the money goes to and they don’t want you to have available revolving debt offered by a line of credit. If you’re buying furniture and paying off a credit card, the lender may want to send checks directly to the furniture and credit card companies themselves.
- State Law Dictates Otherwise: Some states dictate that, for certain reasons, you must go with a cash-out refinance depending on what the money will be used for. For example, if you’re in the state of Texas and need to tap into the equity in your home for certain types of 3rd-party repairs or improvements, state law dictates that the lending company write a check directly to the contractor overseeing the work.
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Home-Equity Line of Credit (HELOC)
A home-equity line of credit (HELOC) offers homeowners the ability to access the equity in their home by means of revolving debt. Using the same examples as above — $200,000 home with $100,000 owed on the mortgage yet $50,000 is needed — the homeowner would be given a line of credit with $50,000 available to spend. You only pay for what you use of this line of credit. As you pay the balance down, that money becomes available again. You could have a $50,000 HELOC yet only use $100 of it, thus you would only owe the bank $100 (+interest and potential fees). Or you could use all $50,000 available and owe the bank $50,000.
HELOC interest rates are usually variable. Oftentimes they are based on the Wall Street Journal’s prime rate give or take a few points or fractions of a point. The semantics are similar to that of a credit card but a HELOC is much different and a much smarter choice. Because there is collateral on the line of credit, interest rates will be tremendously lower with much easier payment terms.
Homeowner’s often consider a home-equity line of credit in these scenarios:
- Home Repairs: Repairs and renovations often have fluctuating costs associated with them. A HELOC gives you the ability to pay some now and then have some to pay later should prices change. Since you only pay for what you use, you can avoid taking out a larger loan than is necessarily needed. (As mentioned above, there are exceptions in states such as Texas)
- Unsure Of Amount Needed: Similar to getting repairs done, there may be an instance where you need access to a large sum of money but are not quite sure of the exact amount needed. A HELOC gives you flexibility when dealing with uncertain costs.
- Emergency Funds: Having a HELOC available is great for emergencies and unforeseen circumstances. If you don’t use it, then you don’t owe the bank anything. If any emergency comes up, then you only pay for what you use.
- Keep Your Mortgage The Same: If you need cash-equivalent equity now but do not want to change the terms of your current mortgage, a HELOC will keep that first-lien mortgage in tact.
It’s worth noting that there is a third option available. For those interested in a cash-out refinance but can’t find a lower interest rate, yet still need the money, you can always go with a straight home-equity loan. The original first-mortgage lien on your home will remain untouched. Meanwhile, a second lien is placed on your home for the amount of cash-equivalent equity you need.
Let’s use the same example as above where one has a home worth $200,000, owes $100,000 on the mortgage, and need $50,000. Your original $100,000 mortgage would remain in tact but a second mortgage would be taken out for $50,000. You would now have two separate monthly payments, one being your original mortgage and the second payment being the second-lien mortgage you have taken out for $50,000.
Home-Equity Line of Credit: The Bottom Line
A flat out home-equity loan without the refinance rarely makes fiscal sense, but it does happen from time to time depending on the current interest rates. It is imperative to get multiple quotes and compare interest rates before making a decision to avoid paying more in the long run.