The Two Different Ways You Can Tap Into the Equity in Your Property
Which Way Is Best?
As your real estate gains value, there are two primary ways that you can tap into the appreciation.
Way 1: HELOC (Home Equity Line of Credit)
Way 2: Cash-Out Refinance
What’s the Difference Between the Two?
Home Equity Line of Credit
A Home Equity Line of Credit - most commonly referenced as a HELOC - is a revolving line of credit, derived from the equity that you’ve built in your home. The size (or amount) of the line of credit is determined by how much equity you’ve accumulated in the property.
For example, if you purchased a home for $450,000 in 2010, but it’s now worth $600K, you’d have $150,000 in equity that you can potentially tap into.
Lenders will often extend a portion of the total equity - such as 70 to 90% - in the form of the HELOC. So rather than receiving a home equity line of credit for the full $150K, you may only be able to leverage $105 - $135,000. The credit amount is ultimately determined by the lender’s guidelines and your borrowing profile.
You can use a HELOC to pay for renovations and upgrades to your existing home, or you can use the funds to purchase an entirely new home. How you spend the capital is totally up to you, and you will only make payments on what you spend.
So if you’re granted a $120K line of credit, but you only use $50,000 to build out an addition to your house, then you will have to make payments on the $50K that was spent. As your balance increases, so will your payments; and as you pay down your balance, your spending power will be restored. A HELOC operates very similarly to an American Express or any other credit card.
Cash-Out Refinance
A Cash-Out Refinance (Refi for short) is when a lender replaces your existing home loan with a new mortgage; and gives you the difference - your equity - between the two loan amounts.
A Cash-Out Refi Works Like This: You purchase a home for $450K in 2015. At closing, you put forth a $50,000 downpayment, and you finance the remainder of the purchase price; giving you an initial mortgage loan balance of $400,000. It’s now 2024 and your home has appreciated in value. It’s now worth $625,000; giving you roughly $225K in total equity (Market Value of $625K - Loan Balance of $400K = $225K) (Keep in mind your loan balance should be a bit lower considering the monthly payments you’ve made towards the loan).
The lender you are working with on the refi is willing to extend to you a new loan at 90% LTV (Loan to Value). Therefore, the new loan amount will be $562,500 (95% of $625K). The loan will first go towards paying off your existing loan balance - which is roughly $400K - then the remaining proceeds, about $162,500, will be given to you in the form of a lump sum check.
Similar to a HELOC, you have complete spending flexibility with the funds you receive from your Cash-Out Refi. You can pay down debt, fund a business venture, or go buy more real estate.
Your monthly payments will be based upon your new loan amount (in this example: $562,500). But unlike a HELOC in which your monthly payments fluctuate depending upon how much you spend, your mortgage payments post-refi will remain the same regardless of what you do with the funds you received.
Which One Should I Use?
Now that you fully understand how both HELOCs and Cash-Out Refis work, the question that usually follows is: Which one should I use to tap into the equity I have in my property?
The short answer is: It depends.
Let me explain:
If you have an existing mortgage with a low interest rate and little to no fees, you should explore a Home Equity Line of Credit rather than a Cash-Out Refinance.
Reason being, you don’t want to disturb the favorable loan terms you’ve secured. By leveraging a HELOC, you can access your home’s equity while keeping your original mortgage in place.
Contrarily, if interest rates have gone down or your credit score has improved since you purchased the property, you may be better suited to do a Cash-Out Refi.
This will allow you to get your initial loan out the way - which presumably had a higher interest rate - and replace it with a new loan that should have more favorable terms.
As you can see, both HELOCs and Cash-Out Refis allow you to tap into the equity you’ve managed to accumulate within your home or investment property. But depending upon a few different factors, one option may be a far better route than the other.
If you’re considering either a Home Equity Line of Credit or Cash-Out Refinance and you’d like to consult with an advisor with regard to the various ways in which you can strategically reallocate your funds, our team is here to help.