Home equity loan vs. HELOC vs. cash-out refinance: what's best?
Comparing different loans - which is the best fit for you?
In Canada, home equity loans and home equity lines of credit (HELOC) are loans that are secured against a borrower's property. While similar, there are key differences between the two that borrowers should know to ensure they choose what is best for them.
Each of these loans is secured against the equity that borrowers have grown in their home.
The equity that an owner has in their home can be increased in several ways:
- A higher original downpayment;
- Through existing monthly mortgage payments;
- The appreciation of the home’s value; or
- Renovations that increase the value of a home.
For example, as homeowners continue to make monthly payments, the equity in their home increases.
Because the loan is backed by the home’s equity. lenders can offer better interest rates than an unsecured loan or line of credit. This makes home equity an attractive way to access additional funds for larger expenses, such as home improvements, saving for retirement or for the downpayment for a second home. Home equity can also be used for smaller expenses, like consolidating higher-interest credit card debt at a lower, manageable interest rate.
Understanding what works in your best interest is vital. In this blog, we'll dive into the three different types of loans that borrowers use to access built-up home equity.
Get a home equity loan
Home equity loans — frequently called a second mortgage or equity loan — allow a homeowner to borrow money from a financial institution based on the percentage of ownership of their home.
A home equity loan is a lump sum payout, so the balance is paid down to $0, like a car loan.
Home equity line of credit
A HELOC — or by its longer name, a home equity line of credit — is a type of loan that uses the borrower's home as collateral against a new loan. The homeowner must own at least 20% of their home to be approved for this loan.
Unlike a Home Equity Loan, a HELOC is a form of revolving credit, available to draw on according to your needs.
A cash-out refinance loan is where a new loan replaces the existing mortgage. However, the second loan is taken out for a more considerable amount, leaving the homeowner to take the extra cash.
How these loans compare
As we mentioned above, while equity loans, HELOCs, or cash-out refinancing have similar qualities, they are distinct types of loans.
Some of the similarities between these loans are to do with eligibility. Homeowners will be subject to income and credit score checks should they apply. Additionally, the amount of home equity needs to meet a specific threshold to borrow against the property.
This principal is referred to as the combined loan-to-value (CLTV) ratio.
For example, a financial institution may have a CLTV ratio of 80%. This is the minimum rate against which they will accept a loan against a property.
A client owns a home worth $400,000. They currently own $200,000 on their first mortgage.
Therefore, $400,000 x 0.80 (CLTV) = $320,000.
Then, minus the $200,000 still owed on the first mortgage, this means the client is eligible for a loan of $120,000 against their property.
Features of home equity loans and home equity line of credit
How does a home equity loan work?
A home equity loan comes in the form of a lump sum of cash. It is typically used when homeowners need a large sum of cash for expenses such as saving for retirement, helping them pay their children’s college education or home renovations.
With home equity loans, many lenders require the borrower to pay points to reduce the interest rates on the loan. Each interest rate point is equal to 1% of the loan value. This means on a $200,000 loan, one point would cost $2,000.
Because each point lowers the interest rate, this can significantly reduce the total loan repayment.
Pros of a home equity loan
- Typically home equity loans can be secured with fixed interest rates. Securing favorable interest rates can help with planning because you will always know your monthly payment amounts.
- As mentioned above, paying points can reduce your interest rates and drive down the total loan amount.
Cons of a home equity loan
- Depending on the amount of cash the borrower needs, a home equity loan might not be the right answer. While many lenders will allow loans for $10,000, others won’t give you one for less than $35,000.
- Borrowers have to pay off the same type of closing costs associated with a primary mortgage, such as origination fees, loan-processing fees, appraisal fees, and recording fees.
- The borrower’s home is used as collateral. If they stop making payments on their home equity loan, they could lose their home to foreclosure.
- Taking out a home equity loan means that a homeowner is responsible for two separate monthly repayments. This could result in financial pressure and reduced disposable income.
How does a home equity line of credit work?
HELOC's are a loan secured against the value of a borrower's property similar to home equity loans. However, a HELOC is a revolving credit, much like a credit card. For example, during a draw period, the HELOC allows homeowners to withdraw money as needed. When a draw period ends, the repayment period begins. From here, the borrower must pay back the principal plus interest.
Unlike traditional home equity loans, they tend to have few, if any, closing costs. Additionally, they usually feature variable interest rates. However, some lenders offer fixed rates for a certain number of years.
Pros of home equity lines of credit
- Borrowers can draw from their credit line at their leisure. However, any untapped funds will not incur interest charges. This can work very effectively as an emergency source of funds. However, that is conditional on the bank not requiring any minimum withdrawals.
- HELOC loans typically have lower closing costs than other home equity loans.
Cons of home equity lines of credit
- There are higher rates and increase in payments during the repayment period vs. the draw period.
- A HELOC is a secured loan. This means that homeowners are putting their home up as collateral for the loan. While this detail can result in lower interest payments, it poses a considerable risk.
How does cash-out refinancing work?
A cash-out refinance loan type works by allowing borrowers to take out a new mortgage to replace their original loan. Because the new loan is larger than the balance on the primary mortgage, the borrower pockets the extra cash from the outstanding balance.
Similar to HELOC or home equity loans, homeowners can utilize these funds to consolidate credit card debt or make home improvements to their property.
Borrowers looking to generate a large lump sum of cash against their home equity should get their loan officer to run the numbers on each option. From there, they can understand which refinance or loan makes more sense.
Pros of cash-out refinances
- Interest rates can be significantly favorable if they have dropped since the original loan.
Cons of cash-out refinances
- Cash-out refinances tend to have closing costs that are much higher than HELOCs, which tend not to have steep upfront fees.
- Refinancing can leave homeowners with less than 20% equity in their homes. In these scenarios, many lenders will expect a homeowner to pay private mortgage insurance (PMI). Once a homeowner reaches 20% home equity, they can choose to cancel this PMI. However, in most situations, homeowners tend to keep this insurance.
- Once again, these loans come with a risk of foreclosure. Paying off unsecured debt with secured debt is never a great idea.
- Cash-out refinances loans can leave borrowers with a higher interest rate or higher monthly payments.
Alternatives to home equity loans
Of course, while all these methods work, they each have their drawbacks. However, a new kind of thinking in the finance world has seen lenders develop fairer ways for borrowers to access a lump sum of cash.
A Fraction Appreciation Mortgage is a far better way for borrowers to use their home equity. Some of the advantages it has are:
- Interest rates that follow with the changing value of your home
- No income requirements
- No age requirements
- Not restricted to primary residence
- No penalties
- Low minimum rate
The difference between home equity financing vs. refinancing
How does an appreciation mortgage work?
An appreciation mortgage is a way for homeowners to access home equity. If the balance of a mortgage is more than 60%, this means there is a large amount of earned equity in the home. As detailed above, there are several ways that homeowners can access this cash.
However, many refinance deals have unfavorable loan terms or come with a high-interest rate. In particular, some refinance deals will require homeowners to take out a new mortgage and pay monthly payments — often at the risk of foreclosure.
Some other loans will require a second payment to be paid on top of a mortgage. All of this places challenging demands on homeowners who have already paid their mortgage.
The Fraction Appreciation Mortgage: a more flexible solution
All-in-all, there are options out there depending on your needs and situation. Whether you’re planning or already retired, looking to diversify your equity, or tired of monthly payments and looking for an alternative, Fraction can help.
Unlock up to $1.5M of your home equity while staying in the home you love. Plus, there are no monthly payments or unfair interest rates.
Get your free estimate today.