It has been a while since my last mortgage match-up, so without further ado, let’s discuss a new one: “Cash out vs. HELOC vs. home equity loan.”
Yes, this is a three-way battle, unlike the typical two-way duels found in my ongoing series. Let’s discuss these options with the help of a real-life story involving a buddy of mine.
A friend recently told me he was refinancing his first mortgage and taking cash out to complete some minor renovations. I asked how much cash he was getting and he said something like $30, 000.
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Here in Los Angeles, $30, 000 isn’t what I’d call a large amount of cash out. It might be in other parts of the country, or it may not.
Anyway, I asked him if he had considered a HELOC or home equity loan as well. He said he hadn’t, and that his loan officer recommended refinancing his first mortgage and pulling out cash.
For the record, a loan officer will probably always point you towards the cash out refinance (if it makes sense to do so, hopefully).
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Why? Because it works out to a larger commission since it’s based on the full loan amount. We’re talking $530, 000 vs. $30, 000.
Now the reason I bring up the amount of cash out is the fact that it’s not a lot of money to tap while refinancing a near jumbo mortgage.
My buddy could just as well have gone to a bank and asked for a line of credit for $30, 000, or even applied online for a home equity loan of a similar amount.
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The upside to either of these alternatives is that there aren’t many closing costs associated (if any), and you don’t disrupt your first mortgage.
Conversely, a cash out refinance has the typical closing costs found on any other first mortgage, including things like lender fees, origination fee, appraisal, title and escrow, etc.
In other words, the cash out refi can cost several thousand dollars, whereas the home equity line/loan options may only come with a flat fee of a few hundred bucks, or even zero closing costs.
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You may also be able to avoid an appraisal if you keep the LTV at/below 80% and the loan amount below some key threshold.
Another advantage to a HELOC or HEL is that you don’t disrupt your first mortgage, which may already have a nice low fixed rate.
It may also be close to paid off, with most payments going toward principal. In that case, you may not want to mess with it late in the game.
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Adding cash out to a first mortgage could also potentially raise the LTV to a point where mortgage insurance would be required; clearly that would be no bueno.
Adding a second mortgage via a HELOC or HEL allows you to tap your equity without touching your first mortgage or raising the LTV (just the CLTV).
Now this potential pro may not actually be an advantage if the mortgage rate on your first mortgage is unfavorable, or simply can be improved via a refinance.
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It turned out that my pal had a 30-year fixed rate somewhere in the 5% range, and was able to get it down under the 4% realm with his cash out refinance, a win-win.
The mortgage was also relatively new, so most payments still went toward interest and resetting the clock wasn’t really an issue. For him, it was a no-brainer to just go ahead and refinance his first mortgage.
When everything was said and done, his monthly payment actually dropped because his new interest rate was that much lower, despite the larger loan amount tied to the cash out.
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Keep in mind that it could go the other way. If you take a lot of cash out on your first mortgage, there’s a chance you could raise the LTV to a point where your interest rate goes up.
For the sake of comparison, let’s assume he had a super low rate of 3.25% on a 30-year fixed. He wouldn’t be able to match that rate, let alone beat it.
In this case, he’d maybe be better off going with a HELOC or HEL instead to keep the low rate on his first mortgage intact.
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That relatively low loan amount ($30k) also means it can be paid back fairly quickly, as opposed to say a $100, 000 HELOC or HEL, even if the interest rate is a bit higher.
The downside to a HELOC is that the rate is variable, tied to the prime rate, which was recently raised for the first time in several years and faces future increases as the economy improves and inflation is contained.
Fortunately, the low loan amount means he can pay it off quickly if rates really jump, though chances are they’ll slowly inch up .25% every few months (but who knows with the Fed).
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Additionally, HELOCs use the average daily balance to calculate interest, so any payments made during a given month will make an immediate impact.
This differs from traditional mortgages that are calculated monthly, meaning paying early in the month will do nothing to reduce interest owed.
A HELOC also gives you the option to make interest-only payments, and borrow only what you need on the line you apply for.
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This provides extra flexibility over simply taking out a loan via the cash out refi or HEL, which requires the full lump sum to be borrowed at the outset.
However, if he chose the home equity loan instead, he could lock-in a fixed rate and pay back the loan faster and with less interest.
The HEL option gives him the certainty of a fixed interest rate, a relatively low rate, and options to pay it back very quickly, with terms as short as 60 months.
What Is A Home Equity Loan?
For someone who needs money, but doesn’t want to pay a lot of interest (and can pay it back pretty quickly), a HEL could be a good, low-cost choice if they’re happy with their first mortgage.
Every situation is different, but hopefully this story illustrated some of the pros and cons of each option. Here is a list of the potential advantages and disadvantages of each for the sake of simplicity.A house can be an important asset to have in your financial portfolio. However, because a house is not a bank account, that value can be hard to access when you need it most. Fortunately, there are several loan options that can help you turn that home value into cold, hard cash. These options include the home equity line of credit, or HELOC, which allows you to borrow against the equity in your home. Equity is the difference between the present market value of the home and what you owe on your mortgage loan. Although Rocket MortgageⓇ doesn't offer HELOCs, we can help you review how they work and compare them to other home equity options so you can decide if it’s right for you while you refinance your assets . Let’s go over everything you need to know.
Home equity lines of credit and home equity loans both allow you to use the equity you’ve built up in your home. Interest rates for home equity loans are fixed, whereas HELOC interest rates vary. Home equity loans give you one lump sum, whereas HELOCs provide funds as needed.
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A home equity line of credit is a type of second mortgage that allows homeowners to borrow money against the equity they have in their home and receive that money as a line of credit. Borrowers can use HELOC funds for a variety of purposes, including home improvements, education and the consolidation of high-interest credit card debt . Sound a little confusing? We’ll break it down for you.
Qualifying for a home equity line of credit is a lot like qualifying for a mortgage refinance. You’ll have to meet certain requirements before you can get this type of loan. The exact HELOC requirements will vary from lender to lender, but you typically need: Reliable income: Many lenders will need proof of income to confirm you’ll be able to pay off your loan payments. Good credit: A credit score above the mid-600s will likely approve you for a loan. A credit score above 700 is considered ideal. Qualifying amount of equity in your home: You should have at least 15% – 20% home equity. Responsible payment history: Lenders may evaluate your previous payment history to make sure you haven’t made any late payments in the past. A low debt-to-income ratio (DTI): The lower your DTI, the better. Discuss with your lender what their qualifying DTI ratios are to potentially receive a loan. Overall, HELOC requirements are similar to the requirements to refinance a mortgage. Make sure you review each to get the best understanding of the options available to you.
A HELOC has two phases that separate borrowing and repayment, also known as the draw period and the repayment period. Be aware, however, that you’ll make payments on the loan during both periods. Phase 1: The Draw Period The first phase, called the draw period, is when your line of credit is open and available for use. During this period, you’ll be
