Home equity loan, HELOC, or cash-out refinance?

Start with the purpose of the borrowing

Define the amount you need, when you need it, and how you will repay it. A single known expense and a renovation paid in stages are different cash-flow needs. Explore alternatives before deciding that available home equity should become new debt.

Equity is the difference between the home’s value and the debt secured by it. It does not automatically equal the amount a lender will let you borrow. Lenders apply eligibility, valuation, and loan-to-value requirements. An estimate of equity is not an approval.

Understand which loan changes

A home equity loan generally adds a separate lump-sum loan with its own payments. A HELOC provides a credit line with draw and repayment rules; variable-rate features can affect the payment. Read the agreement for minimum payments and how the obligation changes after the draw period.

A cash-out refinance replaces the first mortgage with a larger new loan. If you already have a favorable first-mortgage rate, repricing that entire balance can be a significant tradeoff. Compare the combined costs of keeping the first mortgage and adding a second loan against replacing it.

Treat the collateral risk seriously

Turning unsecured debt into debt secured by a home changes the consequences of missed payments. A lower interest rate does not remove that risk. Consider the repayment plan, the stability of the income supporting it, and whether the borrowing addresses or postpones a recurring budget shortfall.

Request clear payment examples and all upfront and ongoing fees. For variable-rate borrowing, ask for a higher-rate scenario. Avoid making the decision based only on the first payment or the amount of cash offered.

How much equity you can borrow against

Lenders usually look at your combined loan-to-value ratio: everything you would owe on the home, divided by its appraised value. Each lender sets its own maximum. As an illustration, on a home valued at $450,000 with a $250,000 mortgage, an 80% limit allows $360,000 of total debt, leaving up to $110,000 of new borrowing. At 85%, the ceiling rises to $382,500, or $132,500 of new borrowing.

That ceiling is not the amount you should borrow. Lenders also review your credit, income, and debt-to-income ratio, and an appraisal can come in lower than you expect. Borrowing less than the maximum leaves a cushion if home values fall or you need to sell sooner than planned.

Sources: CFPB: Home equity loans · CFPB: How a HELOC works · CFPB: Debt-to-income ratio

The three options side by side

The biggest structural difference is what happens to your first mortgage. A home equity loan and a HELOC sit behind it as a second loan, so your existing rate and payment stay the same. A cash-out refinance pays off the first mortgage and replaces it with a larger new loan at today’s rates.

Sources: CFPB: Home equity loans and HELOCs · CFPB: What you should know about HELOCs (PDF)

Worked example: $40,000 with a low-rate first mortgage

Suppose you need $40,000 and already owe $250,000 at 3.50% with 25 years left, a $1,251.56 monthly payment. Using hypothetical rates, compare a cash-out refinance into a new $290,000, 30-year loan at 6.75%; a $40,000, 15-year home equity loan at 8.25%; and a $40,000 HELOC at 8.50%, interest-only for now.

The cash-out refinance has the highest payment and about $39,000 more interest over five years than keeping the 3.50% mortgage and adding a home equity loan, because it reprices the entire $250,000, not just the new $40,000. The HELOC has the lowest payment for now, but only because no principal is being repaid: the $40,000 is still owed after five years, the rate can change, and when a 20-year repayment period begins at 8.50%, the HELOC payment rises from $283.33 to $347.13. If your current mortgage rate were higher than new rates, the comparison could favor the cash-out refinance instead, which is why your existing rate is the first number to check.

Sources: CFPB: Alternatives to a HELOC

Taxes, fees, and the fine print

Whether interest on home equity borrowing is tax deductible depends on how you use the money and on current IRS rules. IRS Publication 936 explains the home mortgage interest deduction. Ask a tax professional before counting on a deduction in your plans.

For a HELOC, the CFPB’s HELOC booklet lists costs to ask about, such as appraisal and application fees, closing costs, annual or transaction fees, and fees for closing the line early. It also explains how the variable rate is set and warns that some plans end with a balloon payment, where the remaining balance comes due at once.

Sources: IRS: Publication 936, home mortgage interest · CFPB: What you should know about HELOCs (PDF)

Options that do not put your home on the line

Borrowing against your home is not the only way to fund a project or consolidate debt. The CFPB lists alternatives such as a personal line of credit, which is based on your credit rather than your home, usually with a lower limit and a higher rate. A personal loan works similarly as a lump sum with a fixed repayment schedule.

A higher rate on unsecured borrowing can still be the better fit for a smaller or shorter-term need, because missed payments do not put your home at risk. Phasing a renovation, paying for part of it from savings, or waiting until you have built a larger cushion are also options worth pricing before you pledge your home as collateral.

Sources: CFPB: Alternatives to a HELOC

If rates change after you borrow

The three options respond differently to future rates. A HELOC’s variable rate moves with its index, so its payment can fall as well as rise. A fixed-rate home equity loan keeps its rate either way; if rates drop, you would need to refinance or pay it off early to benefit, so ask whether the loan has a prepayment penalty. A cash-out refinance sets a new rate on the entire mortgage balance, which is why it is the option most sensitive to the rate you give up.

Some HELOCs let you convert part of the balance to a fixed rate, which the CFPB notes is typically higher than the variable rate but more predictable. That feature can make a line behave more like a loan once the spending is done. Ask about conversion fees and minimums.

Sources: CFPB: Home equity loans and HELOCs · CFPB: What you should know about HELOCs (PDF)

Your next-step checklist

• Define the expense, the timing, and your repayment plan.
• Calculate your combined loan-to-value at a conservative home value.
• Compare total monthly payments across all loans, not only the new one.
• Compare five-year interest and remaining balances.
• Stress-test any variable-rate or interest-only payment.
• Ask about every upfront and ongoing fee, and any balloon payment.
• Consider the risk to your home before borrowing.