If you need a large amount of cash for a home repair or other big expense, you may consider using the equity in your home to get it. This can be done through a cash out refinance or a home equity loan. There are pros and cons to each and the best option may be dependant on your specific situation.
What is a Cash Out Refinance?
In order to do a cash out refinance you need to have some built-up equity in your home or investment property. This may be a result of paying down your mortgage or an increase in your home’s value. Then, you get a brand new mortgage that pays off the old one and likely includes a certain amount of cash on top of that to use as you would like — potentially for a home repair, a child’s college bill, or other large expense.
You may be able to improve the terms of your original mortgage, whether by a lower interest rate, shorter term length, or a fixed interest rate instead of a variable one. Plus, first mortgages typically qualify for lower interest rates than home equity loans (also known as second mortgages) and are easier to qualify for since banks like to be the “first position” lender on a home.
This means that if you lost your home due to foreclosure, they’d have the first chance to recoup their money, in advance of another lender in “second position.”
With mortgage interest rates being at historic lows, you may have already secured one in the 3-5% range. Applying for a cash out refinance could actually result in a higher interest rate than you currently have. Since you’re also applying for a new mortgage, all closing costs apply, and these can typically be higher than they would be if you opted for a home equity loan.
Home Equity Loans
For the sake of simplicity, we’ll lump home equity loans and home equity lines of credit (HELOCs) in the same section here. Both take the equity you have saved in your home and subtract any existing mortgage that applies to arrive at the amount of money you can access. However, it’s important to note that most lenders only loan 80% loan-to-value (LTV) and the amount they lend can depend on things like your credit score and income. If you own a home worth $200,000, 80% LTV would be $160,000. Subtract an existing mortgage of $120,000 and you would have $40,000 of accessible funds, provided the bank approves you.
While home equity loans both use your home’s equity as collateral to take out cash, there are some key differences. Home equity loans function like regular mortgages in that they typically have fixed interest rates and you make a monthly payment of the same amount for the life of the loan. HELOCs, on the other hand, work like a credit card. You don’t make any monthly payment unless you carry a balance on the loan and interest rates are most likely variable. Some HELOCs offer interest-only payments up until the end of the draw period, in which you then make principal and interest payments for the repayment period.
HELOCs and home equity loans usually have much smaller closing costs than a mortgage, so if you think you can pay the loan off quickly and only need a small amount of money, this may be the way to go. Additionally, if you already have a low interest rate on your mortgage, you might not want to ruin a good thing by refinancing the entire amount into a higher interest rate. A home equity loan would allow you to get the cash you need for the higher interest rate, while keeping the bulk of your mortgage at the lower rate.
With a HELOC in particular, and occasionally a home equity loan, the interest rate is variable, so you’ll be at the mercy of the market. There is typically a cap on how high the interest rate can rise, but it is quite high — usually in the upper teens, much higher than the typical 5% with a mortgage. Plus, with home equity loans/HELOCs, you’re getting a second loan on your home, and you will still need to pay your monthly mortgage payment at the same time. Since these types of loans are frequently for shorter terms, you could be paying more monthly than you would with a single cash out refinance that could be stretched over 30 years.
Which is Best?
It’s hard to make a concrete judgment without knowing all the specifics, but a good rule of thumb is that the more cash you need, the more attractive a cash out refinance might be. Interest rates are also key — if you already have a great interest rate on your mortgage, don’t mess that up with a cash out refinance. But, if you’re able to improve on your mortgage terms, it may be something to consider.
If you’re considering either option to finance a second home or purchase an investment property, seek out an experienced real estate agent for guidance and support on this multi-faceted decision. Either way, Clever Partner Agents are able to offer on-demand showings — sometimes in less than an hour — so you know you won’t miss out on a good property. Plus, you’re eligible for a $1,000 buyer’s rebate on any home you purchase for more than $150,000.