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Homeowners in need of cash can often tap into their home equity to obtain it. This means borrowing against the ownership you have of your home to access cash at a low interest rate.
Financial institutions offer a number of ways to borrow against home equity, and the right method depends on your situation. Typically, homeowners seek out home equity loans or lines of credit (HELOCs) to access their equity, but a cash refinance can achieve a similar result.
How does a HELOC work?
A HELOC is a line of credit secured by the equity in your home. Most lenders allow eligible homeowners to borrow up to 80% or 90% of the equity in their home.
HELOCs are interest-only loans for a specific term, such as 10 years. Since payments during this time are strictly interest – not principal – they will likely be lower than regular mortgage payments, which include both principal and interest.
The first part of a HELOC term is the draw period. This means you can withdraw whatever you need from the loan, when you need it, up to the total approved limit. Each month, you only pay interest on the amount of the loan you have used, so you may not pay interest on the full amount you are entitled to. However, HELOCs are generally adjustable rate loans based on the prime rate, which means your interest rate could potentially increase over time.
After the repayment period ends, the repayment period begins, during which you will pay a combined payment of interest and principal each month until the loan is repaid.
Another thing to consider: Given that mortgage interest rates are historically low, HELOCs can be hard to come by. “Some banks aren’t even accepting HELOC applications because they have so many applications for buying and refinancing mortgages,” says Brian Jass, CRPC and adviser at Great Waters Financial in Minneapolis.
How does a mortgage loan work?
Similar to a HELOC, a home equity loan is secured by the equity in your home. But instead of allowing you to withdraw what you need when you need it, a home equity loan is paid to you in one lump sum.
Like a first mortgage, a mortgage loan allows you to borrow a specific amount for a fixed term. The amount you can borrow is usually a percentage of the equity in your home, such as 80%. Since you get the full amount up front, your payments include both principal and mortgage upfront. Some home equity loans offer a fixed rate, just like a traditional mortgage. You can find home equity loans with terms of five to 30 years.
How does cash-in refinancing work?
When you refinance a mortgage, you pay off your existing mortgage and open a new mortgage. People often refinance to get a lower mortgage rate or better terms. Many lenders allow eligible borrowers to “cash out” some of the equity in their existing property as part of the refinance process. With today’s low mortgage interest rates, a cash refinance could allow homeowners to access cash and get better mortgage terms at the same time.
For example, imagine your house is worth $300,000 and you owe $200,000. If your lender offers a refund of up to 80% of the value of your home, you will be allowed to borrow a total of $240,000. With a cash refinance, you could access $40,000 in cash and get a new $240,000 mortgage. Although your mortgage amount is higher, your payment could be less or about the same, if you could get a lower interest rate. And you would have $40,000 in cash for a renovation, tuition, or any other need.
A cash refinance allows a borrower to take advantage of fixed, low interest rates over the term of the mortgage, such as 15 years or 30 years, but these rates may not be the lowest of the lowest. “The interest rate is different for a direct refinance than for a cash refinance,” explains Jass. “Usually you’ll pay about half a percent more to get that money back.”
It is often easier to qualify for a cash refinance than for a home equity loan or HELOC. This is because the loan you get with a withdrawal refi replaces your original mortgage, allowing the lender to hold your first mortgage. HELOCs and home equity loans are considered second mortgages: if you are in default, they will not be paid off until after your first mortgage is paid.
Determine which is the right choice
If you’re choosing between a HELOC and a cash refinance, the right choice depends on your particular needs and timeline. Generally, it’s important to consider when you plan to use the money – now, later, or in installments – and how long you plan to stay in your home.
For example, if you don’t need all the cash at once, but just want it available on demand, a HELOC is probably your best option. With a HELOC, you have access to the agreed amount of money, but only withdraw what you need when you need it. So you can withdraw $10,000 now to remodel your kitchen and another $10,000 next year to remodel your bathrooms. Or you can’t withdraw money at all, just keeping the account open in case of layoff or furlough. Each month you only pay interest on the amount you have withdrawn, or you pay nothing if you have not withdrawn any money.
On the other hand, if you need the full amount you’re borrowing right now, a cash-out refinance may be ideal. You can access the cash you need and take advantage of historically low interest rates on your mortgage. By accessing cash through a mortgage refinance, you benefit from a low interest rate for the life of your loan.
However, refinancing is generally only a good idea if you plan to stay in your home for at least five years or more. This is because the closing costs you’ll have to pay to refinance could negate the interest savings if you only have the loan for a few years. HELOCs, on the other hand, often do not involve closing costs, but you may have to pay fees, including annual fees.
The best option may also depend on the current mortgage rate environment and the interest rate you are paying on your current mortgage. Right now, when rates are particularly low for new and refinanced mortgages, people who want to leverage their principal may be more interested in cash refinances.
However, when mortgage rates start to rise, “people will want to access capital with a HELOC rather than a refinance, because they don’t want to lose their low mortgage rate,” predicts Frank DiMaio, senior vice president and chief sales officer. at Univest. Bank and Trust Co.