Home equity loan vs cash-out refinancing: pros and cons

Many Americans are suddenly wealthy at home. On paper anyway.

Soaring home prices have resulted in a record amount of home equity. At the end of last year, around 46 million homeowners had a total of $ 7.3 trillion in equity to operate, the highest amount on record, according to Black Knight, a mortgage research and technology company – the equivalent of approximately $ 158,000, on average, per owner. .

This, along with near-bottom mortgage interest rates, has prompted a growing number of borrowers to withdraw money from their homes.

In the first quarter of 2021, the amount of home equity collected reached $ 49.6 billion, the highest level since 2007, during the last real estate boom. Including home equity lines of credit, Americans have withdrawn a total of $ 70.4 billion in recent months, according to the most recent data from Freddie Mac.

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Although the volume of withdrawals was the highest in almost 15 years, considering owners’ equity, “the amount cashed out is quite modest,” said Len Kiefer, deputy chief economist at Freddie Mac.

However, it is not always easy to access this money. Since the start of the Covid pandemic, the entire industry has tightened access to mortgages and several major banks have completely stopped offering home equity lines of credit and cash refinances to reduce their exposure – or their risk – in times of economic uncertainty.

How a HELOC and a cash-out refinancing differ

Until last year, a HELOC, which is a revolving line of credit but with better rates than a credit card, was a popular way to borrow against the equity you have built up in your home.

The average interest rate on this type of credit is 4.86%, according to Bankrate.com. Meanwhile, credit cards charge almost 16% on average.

Some banks still offer this option, although most have tightened their standards, at least somewhat. This means that homeowners must have higher credit scores and lower debt-to-income ratios.

“Generally, the higher your credit score, the easier it will be to access home equity,” said Tendayi Kapfidze, chief economist at LendingTree.

There is a better way to free some of that money, however, he added.

“Because the interest rates are so low, your best bet will be cash refinancing,” Kapfidze said. “The rates are lower than a home equity loan and lower than your current mortgage rate.”

Homeowners can also deduct interest on the first $ 750,000 of the new mortgage if the withdrawal funds are used to make capital improvements (although fewer people are detailing now, most households will not benefit from this write-off) .

This works well when mortgage rates go down, because even if you refinance your current mortgage and take out a bigger mortgage, you’re lowering your interest payments at the same time.

“Substantial opportunities continue to exist today as nearly $ 2 trillion in compliant mortgages have the capacity to refinance and reduce their interest rates by at least half a percentage point,” Freddie Mac chief economist Sam Khater said in a recent statement.

“If you haven’t looked at interest rates in the past year, now would be a great time to check this out,” said certified financial planner Douglas Boneparth, president of Bone Fide Wealth in New York City.

On a 30-year mortgage, rates below 3% are still widely available. “Even those who received fairly low rates now find themselves refinancing at lower rates,” Bonparth said.

Still, the most preferable terms go to borrowers with high credit scores. “Most people have pretty good credit, but the best rates go to those with 740 or more,” added Greg McBride, chief financial analyst at Bankrate.com.

It’s not 2005, you can’t take every penny you have at home.

Greg McBride

Chief Financial Analyst at Bankrate.com

Of course, there are also some limitations for cash refinances.

For starters, most lenders will require that you keep at least 20% of the equity in your home, if not more, as a cushion against falling home prices.

“It’s not 2005, you can’t take every penny you have in the house,” McBride added.

Additionally, refinancing with withdrawal often means an extension of your repayment term, which can reduce your monthly budget in the long run, as well as having to pay closing costs up front.

As a rule of thumb, “if you can cut your rate from half to three-quarters of a percentage point, it’s worth thinking about,” McBride said. “This is usually the tipping point.”

Then “you can recoup your costs in a year and a half,” he said, and “the refinancing becomes very convincing.”

Finally, the refinancing opportunities could be short-lived. Mortgage rates will not stay low indefinitely, especially as inflation rises.

“This should add some urgency to getting refinancing as soon as possible,” McBride said. “The economy is heating up – these are the conditions that are producing higher mortgage rates.”

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