If you’ve been making payments toward your home for a number of years or live in an area that’s seen increases in home values, you may have more equity in your home than you did even a few years ago. And if you’re like most homeowners, you have a hearty list of home renovation projects you’d love the opportunity to work on.
One way to access the cash necessary to fund a renovation or addition is by tapping into the equity you’ve built up in your home, through a home equity loan. While a home equity loan can be used for any purpose, it is common to invest the money back into your property. A great tool to use to help determine how much your next renovation will cost is SoFi’s Home Improvement Cost Calculator.
How does a home equity loan work? First, it is important to understand that “home equity loan” is simply a catchall for the several different ways you use the equity in your home to access cash. The most common types of home equity loans are fixed-rate home equity loans, home equity lines of credit (HELOCs), and cash-out refinancing. Today, we’ll explore each of these types of home equity loans, who each type of loan might be best for, and discuss mortgage vs home equity loans.
Breaking Down the Main Types of Home Equity Loans
When folks think of home equity loans, they typically think of either a fixed-rate home equity loan or a home equity line of credit (HELOC). There is a third way to use your home equity to access cash, and that’s through a cash-out refinance. We’ll come back to that, but first, let’s look at the fixed-rate loans and HELOCs.
With both of these home equity loans, the primary benefit is that you can generally qualify for a better interest rate using your home as collateral than by using an unsecured loan (a loan that is not backed by collateral). In fact, it is quite common to use lower-rate home equity loans to pay off higher-interest debt, such as credit card balances.
This does not come without its risks, of course; Borrowing against your home could leave it vulnerable to foreclosure if you’re unable to pay back your loan. If you are looking to pay down debt, invest in your home, or just need cash and don’t want to put your house up as collateral, a personal loan may be a better fit for your situation.
How much a homeowner can borrow is based on the combined loan-to-value ratio (CLTV ratio) of the first mortgage plus the home equity loan. Generally, this figure cannot exceed a 90% CLTV. To calculate your CLTV, divide the combined value of the two loans by the appraised value of your home.
Of course, qualifying for a home equity loan, including the terms, interest rate, and amount you can borrow, is also contingent on the credit score and financial standing of the borrower. One way to help improve the value of your home is by undergoing a renovation. To help determine how much value your next remodel project will bring use this Home Project Value Estimator.
Fixed-rate Home Equity Loans:
Fixed-rate loans are pretty straightforward; The lender provides one lump sum payment to the borrower, which is to be repaid over a period of time with a set interest rate. Both the monthly payment and interest rate remain the same over the life of the loan. Fixed-rate home equity loans typically have terms that run from five to 15 years, and must be paid back in full if the home is sold.
With a fixed-rate equity loan, the amount of closing costs is usually similar to the costs of closing on a mortgage. When you’re shopping around for rates, always be sure to ask about the lender’s closing costs and all other third-party costs. These costs vary from bank to bank, and your goal should be to spend as little as possible on the entire process.
This loan type is best for: Borrowers with a one-time or straightforward cash need. Say, for example, a borrower wants to build a $20,000 garage addition and pay off a $4,000 medical bill. A $24,000 lump sum loan is made to the borrower who would then simply pay back the loan with interest. Additionally, some people might not want the temptation of additional access to credit, which you might get with a HELOC (see below).
This option could also make the most sense for borrowers who already have a mortgage with a great interest rate, or if they are otherwise unable to benefit from refinancing.
Home Equity Line of Credit (HELOC):
A HELOC works like a mix between a checking account and a credit card. It is like a credit card because the money is borrowed and there is an approved limit. Like a checking account, the borrower withdraws the money as needed, using a debit card or special checks.
A HELOC is revolving debt, which means that when you pay down the loan balance, you can borrower it again during the draw period (whereas with a loan, you get one lump sum and that’s it). For example, say that a borrower is approved for a $10,000 HELOC. If they first borrow $7,000, but then pay $5,000 back toward the principal, they now have $8,000 in available credit.
Unlike with a fixed-rate loan, a HELOC’s interest rate will fluctuate with market rates, which means that rates could increase throughout the duration of the credit line. Monthly payments vary because they’re dependent on the amount borrowed and the current interest rate. Similar to fixed-rate loans, a HELOC has a set term and at the end of the term, the outstanding loan amount must be repaid in full.
A HELOC will generally require that the borrower maintain a balance and pay an annual fee. Lenders also generally require you take out a certain amount upfront; There are usually minimum withdrawal amounts. Unlike with a fixed-rate loan or cash-out refinancing, there are usually little-to-no fees that come with opening up a HELOC.
With both fixed-rate home equity loans and HELOCs, all interest payments of up to $100,000 used to be tax-deductible, no matter what the loan was used for. However, because of the Tax Cuts and Jobs Act of 2017, interest on home equity loans is only deductible if the loan is used on qualifying home improvements. If your expenses qualify, the deductions could be a good reason to use a home equity loan or HELOC. You should definitely check with a tax professional for details.
This loan type is best for: People who want the flexibility to pay as they go. If you have an ongoing project, or will need the money partitioned out over longer periods of time, a HELOC might be the best option. For example, a HELOC could provide funds for a child’s higher education costs each semester. This way, a borrower won’t pay interest on money that they won’t be using for another two, three, or four years.
Cash Out Refinance
Mortgage Refinancing is the process of paying off an existing mortgage loan with a new loan from either your current lender or a new lender. Generally, this is done to lower the interest rate or change the duration of your mortgage.
With a cash-out refinance, a borrower can refinance their current mortgage for more than they currently owe, and then take the difference in cash. For example, let’s say a borrower owns a home that is worth $400,000 with a $200,000 mortgage. They would like to do $30,000 worth of repairs to their home, so they refinance for a $230,000 mortgage, taking the difference in cash. Ideally, the new mortgage has a lower interest rate, making their mortgage more affordable in the long term.
Usually, it takes good credit and solid financials for a lender to refinance your mortgage at a lower interest rate. If you think this might be you, it’s definitely worth comparing rates from different lenders. When you refinance, you will also have to decide whether you want a fixed or variable rate mortgage, and whether to change the duration of your loan term.
Extending the duration of the loan may not save you money on interest, even if you receive a lower rate. However, it could lower your monthly payments.
As with home equity loans, there are some costs associated with a cash-out refinance. Generally, a refinance will cost more than a home equity loan, so it’s best to do a refinance only if the improvement in interest rate offsets the costs. Some low-cost lenders, like SoFi, offer competitive refinances with no hidden fees.
This loan type is best for: People who would prefer to have one consolidated loan and those who stand to gain something through the process of refinancing. For example, if you purchased your house 10 years ago with a 6% mortgage interest rate, and now you own more equity in your home and have an improved credit score, you might be able to refinance to a mortgage with a 4% interest rate while also taking out cash.
First Mortgages vs Second Mortgages
Oftentimes, you’ll hear of traditional mortgages referred to as “first mortgages” and home equity loans referred to as “second mortgages.” In some ways, they are similar; In both cases, a bank loans money to the borrower using property as collateral. Both also require a review of the borrower’s financial situation to determine a loan rate, and both options come with a similar set of fees.
But in general, second mortgages or home equity loans come with higher interest rates. This is because second mortgages are considered riskier to the lender. If a borrower stops making payments, the original mortgage would be reimbursed first in the event of foreclosure and sale of the property. The second mortgage would only be reimbursed with what is left over, if anything.
In the case of cash-out refinancing, you’re not taking out a second mortgage—you’re getting a new first mortgage. This makes it less risky, and more straightforward.
Looking to fund a home improvement project or pay off credit card debt? If you’ve got equity in your home, consider a cash-out refinance with SoFi. SoFi offers competitive rates and no origination fees.
SoFi Mortgages not available in all states. Products and terms may vary from those advertised on this site. See SoFi.com for details.
SoFi doesn’t provide tax or legal advice. Individual circumstances are unique. Consult with a qualified tax advisor or attorney.
Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website on credit.