Is a home equity loan better than refinancing

Soaring home prices have resulted in a record amount of home equity on hand. By the end of last year, roughly 46 million homeowners held a total $7.3 trillion in equity to tap, the largest amount ever recorded, according to Black Knight, a mortgage technology and research firm — the equivalent of roughly $158,000, on average, per homeowner.

That, along with near rock-bottom mortgage interest rates, drove a growing number of borrowers to take money out of their homes.

In the first quarter of 2021, the amount of home equity cashed out rose to $49.6 billion — the highest level since 2007, during the last housing boom. Including home equity lines of credit, Americans pulled out a total of $70.4 billion in just the last few months, according to the most recent data from Freddie Mac.

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Although cash-out volume is the highest it's been in nearly 15 years, considering how much equity homeowners are sitting on, "the amount cashed out is pretty modest," said Len Kiefer, deputy chief economist at Freddie Mac.

Still, it's not always easy to access that money. Since the start of the Covid pandemic, the entire industry tightened access to mortgages and several large banks stopped offering home equity lines of credit and cash-out refinances altogether to lower their exposure — or risk — during uncertain economic times.

How a HELOC and a cash-out refinance differ

Up until last year, a HELOC, which is a revolving line of credit but with better rates than a credit card, had been a popular way to borrow against the equity you've accumulated in your home.  

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

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

"Generally, the higher your credit score, the easier it is going to be to access home equity," said LendingTree's chief economist, Tendayi Kapfidze.

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

"Because interest rates are so low, your best bet is going to be cash-out refinance," Kapfidze said. "The rates are lower than a home equity loan rate and lower than your existing mortgage rate."

Homeowners may also be able to deduct the interest on the first $750,000 of the new mortgage if the cash-out funds are used to make capital improvements (although since fewer people now itemize, most households won't benefit from this write-off).

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This works well when mortgage rates fall because even though you are refinancing your current mortgage and taking out a bigger mortgage, you are lowering your interest payment at the same time.

"Substantial opportunity continues to exist today, as nearly $2 trillion in conforming mortgages have the ability to refinance and reduce their interest rate by at least half a percentage point," said Sam Khater, Freddie Mac's chief economist, in a recent statement.

"If you haven't been looking at interest rates over the last year, now would be a great time to check that out," said certified financial planner Douglas Boneparth, president of Bone Fide Wealth in New York.

On a 30-year mortgage, rates below 3% are still widely available. "Even those who received pretty low rates are finding themselves refinancing at lower rates today," Boneparth said.

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

This isn't 2005, you can't pull out every last nickel you have in the home.

Greg McBride

chief financial analyst at Bankrate.com

To be sure, there are some limitations for cash-out refinances, as well.

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

"This isn't 2005, you can't pull out every last nickel you have in the home," McBride added.

Further, a cash-out refinance often means extending your repayment term, which can squeeze your monthly budget in the long run, along with having to pay closing costs upfront.

As a rule of thumb, "if you can reduce your rate by half to three-quarters of a percentage point, it's worth looking at," McBride said. "That's usually the tipping point."

Then, "you can earn back your costs in a year and a half," he said, and "refinancing becomes very compelling."  

And finally, refinancing opportunities could be short-lived. Mortgage rates won't stay low forever, particularly as inflation ticks higher.

"That should add some urgency to getting a refinancing done sooner than later," McBride said. "The economy is heating up — those are the conditions that produce higher mortgage rates."

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