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What’s the top benefit of owning a home? Many would point to the equity you gain as you steadily pay down your mortgage. For instance, if you owe $100,000 on a home worth $150,000, you have $50,000 worth of equity.
You can tap into that equity to help pay for your children’s college tuition, fund the cost of a master bedroom addition or pay down your high-interest-rate credit card debt.
Which of these two options is best for you? As always, it depends on your personal financial situation and your goals.
A home equity loan is a second mortgage. Say you have $50,000 worth of equity in your home. Your mortgage lender might approve you for a home equity loan of $40,000. Once you take out this loan, you’ll receive a lump-sum check for the $40,000, money that you can spend however you’d like.
You do, of course, have to pay that money back. You’ll do this in the same way you’ve been paying your first mortgage: You’ll make regular monthly payments. Your home equity loan will come with a set interest rate and a set payment each month. You’ll make these payments until you pay off your home equity loan in full.
A cash-out refinance is significantly different from a home equity loan. While a home equity loan is a second mortgage, a cash-out refinance replaces your existing home loan.
In a cash-out refinance, you refinance your existing mortgage into one with a lower interest rate. However, you refinance your mortgage for more than what you currently owe. For example, say you owe $100,000 on your mortgage. If you refinance for a total of $150,000, you receive $50,000 in cash — that you can spend on whatever you want. You then pay back your new mortgage of $150,000.
On the plus side, you’ll usually receive a lower interest rate when you apply for a cash-out refinance. That can result in lower monthly payments. On the negative side, refinancing is not free. In fact, the Federal Reserve Board says that homeowners can expect to pay 3 percent to 6 percent of their outstanding mortgage balance in closing and settlement fees when financing.
The interest rate on your existing mortgage, then, becomes a key factor whether a cash-out refinance is a better option than a home equity loan. If your current interest rate is high enough so that refinancing to a lower one will lower your monthly payment by $100 or more a month, then a cash-out refinance probably makes sense. That is because you’ll be able to save enough in a short enough period to cover your refinance costs. Once your monthly savings cover those costs, you can begin to benefit financially from your lower monthly mortgage payment.
If refinancing will only save $30 or $50 a month, then it is unlikely that you’ll save enough each month to recover your refinancing costs quickly enough to reap the financial benefits. In such a situation, a home equity loan is probably your better financial choice.
A home equity loan might make sense, too, when you’ve already held your home loan for a significant number of years. For instance, if you’ve been making payments on your 30-year fixed-rate mortgage for 20 years, you are at the point where more of your monthly mortgage payment goes toward principal and less toward interest. If you are in such a situation, it might make more sense to consider a home equity loan than a cash-out refinance.
Your best option, though, when considering the many ways to tap into your home equity is to meet with a skilled financial planner. This professional can take a look at your existing mortgage and your household finances to determine which method of accessing your home equity makes the most financial sense for you and your family.