Home Equity Line of Credit (HELOC) vs. Refinancing: What's Best for Me?
For the seasoned homeowner, researching how to fund your next big project or life event can bring up a variety of complicated terms. Many of these terms are presented together, but they often work very differently from one another. In this article, we compare a Home Equity Line of Credit (HELOC) to refinancing your existing mortgage. To learn how each option works and when you would want to choose one over another, continue reading.
Home Equity Line of Credit (HELOC)
What is home equity?
Home equity is the appraised value of your home minus any loans or mortgage balances. As you pay down your mortgage balance, or if your property value increases, or you make significant improvements to your home, you build equity. That equity can be borrowed against in the form of home equity loans or lines of credit.
For example, if the value of your home was $100,000 and you still owed $60,000 on your mortgage, your equity in the home would be $40,000.
|(home value) – (principal owed) = (home equity)|
At American Heritage, depending upon your creditworthiness, you’re able to borrow up to 95% of your home’s value, meaning in the above scenario, you would be able to borrow a maximum of $38,000 if approved.
Your down payment is typically the first equity you build in your home, but if your down payment is the only equity you have in your home, you may want to wait until you’ve built additional equity before borrowing against it. There are several ways to build equity in your home, including the principal payments in your monthly mortgage, as well as appreciation, or increase, in your home’s value. Some lenders have a minimum equity requirement that may be higher than your current equity percentage.
How do I use my home’s equity as a line of credit?
A home equity line of credit, or HELOC, is a form of credit. A HELOC differs from a standard home equity loan.
- HELOC: get approved for a maximum amount but only borrow what you need over the course of the “draw” period (typically several years) and repay with either a variable or fixed interest rate during the “repayment” period
- Home Equity Loan: borrow a lump sum up front and repay the loan with fixed monthly payments
In other words, a HELOC is used comparably to a personal line of credit or secured credit card, where a home equity loan is more like a personal loan.
You will have to qualify for a HELOC in a process similar to your mortgage application process, where you must document your income and employment status, and not all applicants are approved. If you’ve been denied, be sure to talk with the lender to learn why you were denied and what your remaining options are.
What is a home equity line of credit used for?
Many homeowners use their HELOC to finance home projects or large-scale renovations. The money borrowed in a HELOC is not required to be reinvested into your home, but it is a smart move to do so. Check with your tax advisor, but in some instances you can deduct the interest payments on your HELOC if the proceeds are reinvested into your home. By using your home’s equity to make home improvements, you can ultimately increase the value of your home and reap a more direct reward. If you plan to sell your home shortly after the renovation, the money borrowed for the project can create a return on investment.
What are some cons of a HELOC?
When taking out a HELOC, you are borrowing against your home’s equity, which means that equity is used as collateral for the loan. If you are unable to repay your HELOC, you could lose your home in foreclosure. Consider using a personal loan or other borrowing alternatives before using your home as collateral.
Using a HELOC to solve short-term cash flow problems or to move debt around, such as borrowing for a car or vacation, are warning signs that you may be spending beyond your means and a home equity line of credit may not be the right solution for you. When your home is on the line, it is best to avoid overspending and to investigate other solutions.
What does it mean to refinance a mortgage?
Refinancing a loan is a process in which you replace a current debt with a new one with more favorable terms. Refinancing can be used to pay off one or many existing loans (consolidation) and is usually performed to acquire a lower interest rate or extend loan terms for a lower monthly payment.
When refinancing a mortgage, borrowers often wish to accomplish one of the following:
- Pay less in interest over time with a lower interest rate
- Shorten their term to own their home more quickly, paying more monthly
- Lengthen their term to lower their monthly mortgage payment
Why should I refinance my mortgage?
Refinancing a mortgage can be a good financial investment depending upon your circumstance. If you purchased your home when the average interest rate was much higher than rates are currently, refinancing could save you thousands over the remaining life of your mortgage.
If you’d like to switch from an adjustable-rate mortgage to a more stable fixed-rate mortgage, refinancing can help provide a predictable monthly payment and avoid the risks associated with increasing rate environments.
Consolidating a home equity line of credit and your mortgage can save you money on variable-rate payments and can make your monthly bills much simpler.
Finally, if the value of your home has risen, you may have enough equity to take out a cash-out refinance, which can provide funds for paying off debt, a renovation or making a large purchase.
When should I refinance my mortgage?
If you’re considering refinancing, keep an eye out for promotions that help you save on closing costs. Average refinancing closing costs can cost anywhere from 2%-5% of your outstanding mortgage balance and will have you paying several thousand dollars upfront.
If you put less than 20% down when purchasing a home, you are required to pay Private Mortgage Insurance (PMI). This insurance does not automatically drop off once you hit 20% equity in your home, but you do have the right to remove it once you have built the required equity and refinancing can be one way to do so.
Other times to think about refinancing are when your home’s value increases or when your credit score improves.
What are some cons of refinancing?
Depending on your lender, the upfront price of closing costs may make refinancing a weak investment. For example, if you are refinancing to make smaller monthly payments, the initial price of closing costs may not be affordable to all borrowers.
Additionally, if mortgage rates are not significantly lower than your current rate, or your credit score is not within range of getting the lowest advertised rate, the time and costs associated with refinancing may not be worth it.
If you’re still doing the math, our calculator will help you figure out if and when you will break even by refinancing.
Which option is right for me?
If you still aren’t sure which financial solution is right for your needs after reading, we can help! Our team is happy to help guide you to the right solution for your needs. Contact us today to get started.