When It Comes To Paying For Home Improvements, Which Is Better: A Cash-Out Refinance, A Home Equity Loan, Or A Home Equity Line Of Credit (HELOC)?

Although these financial instruments share several features in common, they should not be confused with each other. In this article, we’ll help you understand the differences between the three and determine which one may be the best choice for you.

How can I know if I’m a good candidate for a cash-out refinance, a home equity loan, or a HELOC?

Before you begin comparison shopping for mortgages, loans, or lines of credit, first calculate how much home equity you have.

How do I calculate my home equity?

First, confirm your home’s current appraisal value. You should be able to find this figure listed on your annual property tax bill. If you need a copy of your most recent tax bill, you can contact your local county appraisal district for assistance.

Next, verify the amount you still owe on your mortgage. Subtract that dollar amount from your home’s appraised value. This figure represents how much equity you have in your home.

How can I grow my home equity?

Rising property values can increase your home equity, but homeowners have limited control over the real estate market conditions that can cause home values to rise and fall.

However, you can also grow your home equity by paying down your mortgage. In doing so, you’re paying for more of the property itself, meaning your ownership stake in it represents a larger percentage of its value.

What is a cash-out refinance?

A cash-out refinance is a mortgage option available to those who have been in their home long enough to build up a substantial amount of equity. Taking a cash-out to refinance allows you to borrow some of your home equity by replacing your current mortgage with a new one. Your new mortgage will include both the outstanding balance on your existing mortgage and the amount of cash you wish to borrow against this home equity.

By way of illustration, let’s say your house has an appraisal value of $300,000. You still owe $100,000 on your mortgage. Your home equity is equal to $200,000. You’ve also received a $50,000 bid for a new bathroom suite. You might apply to a lender for a new mortgage of $150,000. If the lender agrees, you would then pull that “extra” $50,000 out of your home’s equity to cover the cost of your new bathroom.

Do I have to pay closing costs on a cash-out refinance?

Yes, because a cash-out refinance is a new mortgage, you will have to go through a formal closing process. Closing costs can average between 2 and 5 percent of your total loan amount. Make sure to factor in these costs when comparing individual cash-out refinance offers or a cash-out refinance to a home equity loan or HELOC.

Is the interest I pay on my new cash-out home loan tax-deductible?

Yes, with certain caveats. According to IRS Publication 936, “Home Mortgage Interest Deduction,” you can only deduct your home mortgage interest payments if you use your cash-out amount to “substantially improve” your home.

Are there risks associated with a cash-out refinance?

Like any loan, a cash-out refinance carries a few risks.

• When you cash out, you increase your debt and erase some of the wealth you’ve built up in your home.
• The payments on your new loan may be higher. Should you fall behind on mortgage payments for any reason, you risk default and foreclosure — losing your home.
• If the market changes and your home’s value declines, you may find yourself underwater on your mortgage, owing more than the home is worth. In that situation, you may have trouble refinancing or selling your home.

Does Texas impose any restrictions on taking out a cash-out home loan?

Texas law prevents cash-out refinancing customers from borrowing more than 80 percent of the value of their home. For example, if your home is worth $150,000, the maximum amount you could “cash-out” is $120,000.

Moreover, Texas homeowners must have at least 20 percent equity in their home to be eligible for a cash-out refinance.

What is a home equity loan?

When you take out a home equity loan, you use your home as collateral on a new loan. A cash-out refinance is a new mortgage, whereas a home equity loan is technically a second mortgage — unless you’ve already paid off your original mortgage.

Much like a cash-out refinance does, a home equity loan gives you immediate access to a lump sum. If you know precisely how much money you’ll need to complete your home improvements and are ready to start sooner rather than later, this type of loan may be your best choice. But since you’re using your home as your collateral, failure to repay could put you at risk for foreclosure.

Most home equity loans mature within 10 to 15 years. Compare this to the 30 years you may have to pay off a conventional mortgage. Finally, a mortgage paid off is a mortgage paid off. If you sell your home before repaying your home equity loan, its balance will still be due.

How do home equity loan interest rates compare to cash-out refinance interest rates?

As of this writing (February 2021), mortgage interest rates are very borrower-friendly. Since January 2020, the average rate for a 30-year, fixed-rate mortgage has dropped nearly one full percentage point — from approximately 3.75 percent to 2.95 percent.

Although borrowed cash is relatively inexpensive for homebuyers, homeowners in the market for a cash-out refinance should expect to pay between 3 and 3.3 percent interest on their new loan.

By contrast, home equity loan interest rates currently average about 5 percent, meaning rates on these loans can be as low as 3.25 percent and as high as 7 percent. That said, these rates are lower than those advertised by many personal loans or credit cards.

These higher home equity loan interest rates also often tend to be fixed. (Cash-out refinance rates can be fixed or adjustable.) Again, it helps to remember that a home equity loan is a second — or supplementary — mortgage. That means if you fall behind on payments, the lender will only get paid after the primary mortgage holder receives what they’re owed. This condition makes lending riskier for home equity loan providers.

As always, your credit history will largely determine whether you qualify for a loan carrying the lowest available interest rate.

Does Texas impose any restrictions on taking out a home equity loan?

Under Texas law, home equity loans are limited to 80 percent of the value of the home. This figure is based on what’s called the combined loan-to-value ratio, or CLTV.

The CLTV takes both the balance of your first mortgage and the home equity loan into account. Say your home is currently valued at $300,000. 80 percent of that figure is $240,000. Now, say the balance on your current mortgage is $200,000. Therefore, you may be able to secure a home equity loan of $40,000.

Do I have to pay closing costs on a home equity loan?

Yes, but these costs are typically lower than those associated with a cash-out refinance. Additionally, some lenders may be willing to reduce or waive these costs. Just be sure to check the terms and conditions — those waived costs may come back in the form of a penalty for paying your loan off early.

Is the interest I pay on my home equity loan tax-deductible?

Yes, but you must use the borrowed funds to “substantially improve” your home. For more information, see IRS Publication 936, “Home Mortgage Interest Deduction.”

What is a home equity line of credit (HELOC)?

Like a home equity loan, a HELOC is also a second mortgage that requires an additional monthly payment. Unlike a home equity loan, however, a HELOC gives you flexibility. You still have to manage a total loan amount, but you only borrow what you need during the draw period, pay it off, then borrow again as needed.

HELOCs also typically feature adjustable rather than fixed interest rates. Bear in mind, then, that these rates can rise or fall over the life of the loan. Typically, lenders will offer discounted rates at the beginning of the HELOC’s term. Over time, as those discounts expire, your HELOC’s interest rates will gradually increase.

Which is the best way to pay for home improvements: a cash-out option, a home equity loan, or a HELOC?

The answer to this question depends on several factors. You’ll want to weigh the following when considering how to secure the capital you plan on reinvesting in your home.

• Current mortgage rates. Suppose you can secure a lower interest rate by refinancing, and you intend to stay in your home to reach the break-even point — the point at which your accumulated savings exceed the cost of the new loan. In that case, a cash-out refinance may make more sense than a second mortgage or HELOC.
• How much you want to borrow. If you only want to borrow a relatively small amount of money, a home equity loan may be a better option since you won’t have to pay those hefty mortgage refinance closing costs. If you’re looking for only a little liquidity, a small personal loan or a low-interest credit card might be sufficient.
• Your plans for the money. If your home renovation budget is particularly elastic or your innovation project may need to move through several phases, a HELOC may be your best choice.
• How long you’ll be in your house. If you intend to relocate in the near future, a home equity loan might make more sense than a cash-out refinance or HELOC. With a cash-out refinance, it may take several years to recoup the closing costs you’ll pay upfront. HELOCs tend to have a long lifespan: 10 years for the draw and 20 to repay. If you sell your house before you’ve paid off your HELOC, you’ll have to pay the balance in a lump sum.

Guaranty Bank & Trust’s friendly and collaborative bankers have been helping Texans grow their home equity for over 100 years. Once you’ve determined how much cash you’ll need to beautify or build an addition to your home, make an appointment to speak with one of our mortgage experts. We look forward to finding the home improvement financing option that’s right for you.