HELOC, refinance or home equity loan: What’s the best way to borrow against your home?

If you’re tempted to unlock your home equity for cash, now could be the time: Borrowing against your home’s value hasn’t been this affordable in about a year. But several ways to borrow exist. “Choosing between a home equity loan, HELOC or cash-out refinance isn’t a one-size-fits-all decision,” says Tim Choate, founder and CEO of RedAwning.com, a platform for short-term vacation rental owners and property managers. “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.

HELOC vs. 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 refinances. 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 amount, 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; they are also known as second mortgages.

How do HELOCs work?

A home equity line of credit (HELOC) is a revolving, open line of credit, 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 the plastic. “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, Mich.-based Foguth Financial Group, a wealth management advisory firm.

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.

“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.”

On the downside: It can take a while —a month, say — to get approved for and set up the line of credit. “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,” Foguth says. Also, it can be easy to get in over your head, tapping the credit line for 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.

How do home equity loans work?

A home equity loan allows you to borrow funds in a lump sum. 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 obligation.
• 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. It resets your mortgage terms in the process, which might not be ideal for everyone.

How do cash-out refinances work?

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 when you close, and you’ll repay it as part of your monthly mortgage payments. This new loan becomes your primary mortgage. In contrast, home equity loans and HELOCs exist alongside 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. “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 your home equity stake falls below 20 percent after doing the refinance, a lender might charge you private mortgage insurance (PMI).

Also, since it’s a new mortgage, the cash-out refi requires you to fill out an application; provide proof of income, assets and employment; have a home appraisal; and go through underwriting. — essentially the same drill as when you got your first mortgage.

“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.”

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.

FAQ

• How do you calculate the 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.

  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.

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

  Home equity loans, HELOCs and cash-out refis 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, to quote the IRS. 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.