Home Equity Line of Credit or Cash-Out Refi?

For homeowners interested in making some property improvements without tapping into their savings or investment accounts, the two main options are to either take out a Home Equity Line of Credit (HELOC), or do a "cash-out" refinance.

A Home Equity Loan is similar to the line of credit, except there is a lump sum given to the borrower at the time of funding and the payment terms are generally fixed.

Both a line and loan would hold a subordinate position to the first mortgage on title, and are typically referred to as a "Second Mortgage". Since second mortgages are paid after the first lien holder in the case of default foreclosure or short sale, interest rates are higher in order to justify risk.

 

There are three variables to consider when answering this question:

1.  Timeline;

This is a key factor to look at first, and arguably the most important. Before you look at the interest rates, you need to consider your time line or the length of time you'll be keeping your home and/or this loan. This will determine how long of a period you'll need in order to payback the borrowed money.

For example, are you looking to make home improvements in order to sell your home? Or, are you adding that bedroom and family room addition that will turn your cozy bungalow into the long term home of your dreams?

This is a very important question to ask because the two types of loans will achieve the same result, taking cash out from your home's equity, but they each serve different distinct purposes.

A home equity line of credit, commonly called a HELOC, is better suited for short term goals and typically involves adjustable rates that can change monthly. Because it is a line of credit, another advantage of a HELOC is that you only pay interest on the money as you use it. The HELOC will often come with a tempting feature of interest only on the monthly payment resulting in a temporary lower payment, but perhaps the largest risk of a HELOC can be the varying interest rate from month to month. You may have a low payment today, but can you afford a higher one tomorrow?

Alternatively, a cash-out refinance of your mortgage maybe better suited for securing longer term refinancing with fixed monthly payments, especially if the new payment is lower than the combined new first and second mortgage, should you choose a HELOC. Refinancing into one new mortgage with a lower rate can removes your risk of payment increases in the future.

2.  Costs / Fees;

What are closing costs for each loan? This also goes hand-in-hand with the above time-line considerations. Both loans have charges associated with them, however, a HELOC will typically cost less than a full refinance. It's important to compare the short-term closing costs with the long-term total of monthly payments. Keep in mind the risk associated with an adjustable rate/adjustable  payment that is part of a line of credit.

3.  Interest Rate;

The first thing most borrowers look at is the interest rate. Everyone wants to feel that they've locked in the lowest rate possible. The reality is, for home improvements, the interest rate may not be as important if you intend to only keep the loan for a short period. If your current loan is at 4.875%, and you only need the money for 4-6 months until you get your bonus, it's not as important if the HELOC rate is 5%, 8%, or even 10%. This is because the majority of your mortgage debt is still fixed at 4.875%.

Conversely, if you need the money for a fairly long term and your current loan is at 4.875%, it may make financial sense to consider a new 30-year fixed rate mortgage. There would be a considerable savings over several  years if variable interest rates went up for a longer period of time.

 

Choosing between a full refinance and a HELOC basically depends on how long you plan to keep the HELOC and the level of risk you are willing to accept in regards to the adjustable rate. A simple spreadsheet comparing all of the costs and payments associated with both options will help highlight the total net benefit.

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