Home Equity Loan vs. HELOC vs. Cash-Out Refinance – Which is Best?
Tapping into your home equity is a great way to access a significant amount of money. If you have major expenses such as medical debt, paying for a child’s college tuition or even to make some home improvements, a home financing loan can be a low cost option. However, it’s important to do your due diligence as you may end up paying more for one type of loan over another. Understanding your obligations, including what happens when you default on your loan is crucial to understanding the best choice for you.
Here are some options for home equity financing, including the advantages, pitfalls and who it’s best suited for.
1. Home Equity Loan
How it works: A home equity loan is sometimes called a second mortgage because this type of financing is considered a second loan against your home. Upon approval, you get a lump sum of money and pay back the loan over a set term. Your monthly payments tend to remain the same because home equity loans have fixed rates, meaning the interest rate doesn’t change.
Who it’s best for: This type of loan was best for those who intend on staying in their home for the long term. Having a fixed rate loan helps to ensure you know how much you’re paying each month without the risk of rates rising. Also, it’s best for those who know the exact amount they’ll need to borrow and aren’t intending on taking out any additional loans.
Advantages: Home equity loans tend to have lower interest rates, which could help you save money if you’re using the loan to consolidate high interest debts. That’s because your loan uses your home as collateral. Interest payments may also be tax deductible which is not the case with other types of loans.
Disadvantages: Rates for home equity loans tend to be higher than HELOCs, so this could be a disadvantage if you’re not planning on staying in the home long term. Also if you decide to use your loan for a short-term expense, you’ll pay more in interest over the long term. Home equity loans have closing fees, which could cost you thousands of dollars. And of course, your home could be in jeopardy if you don’t make payments on time.
How it works: A home equity loan (HELOC) is similar to a home equity loan in that you use your home as collateral. However, borrowers get a revolving line of credit, much like a credit card in which to draw funds from. You’re approved up to a certain amount and you can borrow as needed up to the limit. HELOCs tend to have variable interest rates, meaning payments will differ depending on whether interest rates go up or down.
With a HELOC, you’ll have a certain amount of time to withdraw funds as needed, also called the draw period. This usually lasts up to 10 years and during this time, you’ll be paying back interest on the amount borrowed. Once the draw period is over, you’ll enter into the repayment period in which you pay back the interest plus the principal amount.
Who it’s best for: Those who aren’t sure how much money they’ll need to borrow are best suited for a HELOC loan. They may prefer to know they have access to cash over a period of time, whenever they need it. It’s also best for those who don’t intend on staying in their home for the long term, as they’ll be able to take advantage of the lower interest rates offered.
Advantages: HELOCs tend to have lower interest rates than home equity loans because many lenders offer introductory rates. If you don’t intend on living on your home long term, you can take advantage of this. A HELOC also gives you the flexibility to draw funds as often as needed, which can come in handy if you’re not sure how much you’ll need to borrow, such as for a home remodeling project. Like a home equity loan, your interest payments are also tax deductible.
Disadvantages: Like a home equity loan, you’ll also need to pay closing costs, which can add up to a significant chunk of money. As well, you could be paying more in the long run with a HELOC if you stay in the home for a long period time. That’s because interest rates could rise, meaning your monthly payments will go up as well. If your HELOC came with an introductory rate, your monthly payments will go up once that initial period is over. Some lenders may also charge additional fees such as annual membership and maintenance fees, or even transaction fees whenever you withdraw funds from your line of credit. And like other home loans, you could lose your home if you don’t make your payments.
3. Cash Out Refinancing
How it works: A cash out refinance means you’re taking out a new home loan. You’ll borrow an amount that’s more than what you currently owe on your current mortgage. The new loan will be used the pay off the existing loan and the difference will go to you. You may receive a new set of terms and a lower interest rate as a result.
Who it’s best for: Any homeowner that wants to save money on interest with their current mortgage would benefit the most. For example, someone who is looking to make some home improvements finds a lower rate than their current mortgage. Also, those who need access to cash fast may find that they’ll get approved for a cash-out refinancing loan much quicker.
Advantages: Rates for cash-out refinancing tends to be lower than both HELOCs and home equity loans. Your interest payments are also tax deductible. You could save money since you’re now paying a lower rate compared to your original mortgage.
Disadvantages: Closing costs tend to be higher with cash-out refinancing compared to HELOCs and home equity loans. Also, if you’re not borrowing a large sum, you may be better off with a home equity loan or HELOC. Since a cash-out refinance resets the term of your loan, you could be in debt for longer, and pay more interest on the long run. And of course, if you fail to pay the monthly payments you could lose your home.
Before Taking Out a Loan
You should also consider a home ownership investment instead of a loan. For example, with the Unison HomeOwner program from Unison, you can unlock the equity in your home with no monthly payments and no interest charges. Instead, the company shares in the future change in value of your home. In other words, if the home gains value, you both win. If the home loses value, you both typically lose.
No matter which option you choose, understand that you’re using your home as collateral. If you’re not careful, you could end up losing your home if you default on your payments. In other words, make sure you budget carefully and understand what you’re really getting into. A home equity loan can have many benefits, but it’s also an easy way to get into financial trouble.