Cash-Out Refinance vs. Home Equity Line of Credit (HELOC)
Investment Options
As I’ve been working through renovations on both of my properties at the same time, one of the most common questions I get is, “How are you financing the projects?” To be honest, the majority of it is coming from savings. However, a portion of my duplex is being covered by a HELOC.
I am learning along the way, how investors are able to scale at such a quick pace, and I’m very excited to share a couple of different options that I’ve learned over the past 18 months.
HELOC vs. Cash-Out Refinance
There are two very common investment options that are leveraged in real estate that you should know about. Allison Larson of Novus Home Mortgage and I sat down to discuss the difference between a HELOC and a Cash-Out Refinance. Keep reading to learn about my personal investment decisions.
What is a HELOC?
A HELOC, also known as a Home Equity Line of Credit is where you can pull out a line of credit from your property, to leverage for any future investment. Whether you want to take on a renovation, or help pay off student loan or credit card debt at a lower interest rate, a HELOC is a great option.
Certain banks will allow you to borrow up to 90%-95% of your homes value. For example, if you put down 10% when you purchased the home, and have paid down another 10% of the principle during your ownership, you now have 20% equity paid off. Based on having 20% of your loan paid off, the bank will allow you to “borrow back” up to 15% of the 20% through a HELOC.
How Much Does a Home Equity Line of Credit Cost?
This line of credit doesn’t have to be used and can just be set up in case of an emergency, or pulled out for a specific purpose. It is similar to a credit card, where if you don’t use it, you aren’t charged anything except a small annual fee. For example, mine is $25/year.
If you do decide to pull out funds from the HELOC, most banks only require interest only payments and are set up for around 5 years. Therefore, you can decide when you are able to pay back the HELOC in full on your timeline. On top of that, the banks are typically very flexible with extending HELOCs past their lifecycle of 5 years, and may just adjust the rate at that point in time.
The Advantage to a HELOC
One of the biggest advantages of using a HELOC is that it doesn’t impact your mortgage payments. You see, if you have paid down your loan by 20%, your mortgage insurance drops off (when using a conventional loan). This can save individuals anywhere from $50-$500/per month depending on the size of the loan and is a big milestone for many people. When you then are borrowing against the equity you’ve built up with a HELOC, it does not impact your monthly loan payment amounts and also does not call for your interest rate to be adjusted. It’s a great tool to leverage if you have locked in a low interest rate and don’t want to refinance your loan.
What is the Downside of Doing a HELOC?
Home equity line of credit are generally shorter terms with a floating interest rate. What this means is that a bank has agreed to give you a line of credit for 3-5 years, but then after that time period you will need to reinstate the HELOC for another 3-5 years. This isn’t necessarily a bad thing, however, it is worth noting how it impacts the interest rate you’re borrowing against. If your original HELOC was locked in at 4% and rates increase over the next 5 years, you might be locking in a new HELOC at a higher rate. In general, I personally still feel like a HELOC is worth having as a safety net. When comparing it to credit card APR’s, the financing is much more advantageous.
What is a HELOC?
A HELOC, also known as a Home Equity Line of Credit is where you can pull out a line of credit from your property, to leverage for any future investment. Whether you want to take on a renovation, or help pay off student loan or credit card debt at a lower interest rate, a HELOC is a great option.
Certain banks will allow you to borrow up to 90%-95% of your homes value. For example, if you put down 10% when you purchased the home, and have paid down another 10% of the principle during your ownership, you now have 20% equity paid off. Based on having 20% of your loan paid off, the bank will allow you to “borrow back” up to 15% of the 20% through a HELOC.
How Much Does a Home Equity Line of Credit Cost?
This line of credit doesn’t have to be used and can just be set up in case of an emergency, or pulled out for a specific purpose. It is similar to a credit card, where if you don’t use it, you aren’t charged anything except a small annual fee. For example, mine is $25/year.
If you do decide to pull out funds from the HELOC, most banks only require interest only payments and are set up for around 5 years. Therefore, you can decide when you are able to pay back the HELOC in full on your timeline. On top of that, the banks are typically very flexible with extending HELOCs past their lifecycle of 5 years, and may just adjust the rate at that point in time.
The Advantage to a HELOC
One of the biggest advantages of using a HELOC is that it doesn’t impact your mortgage payments. You see, if you have paid down your loan by 20%, your mortgage insurance drops off (when using a conventional loan). This can save individuals anywhere from $50-$500/per month depending on the size of the loan and is a big milestone for many people. When you then are borrowing against the equity you’ve built up with a HELOC, it does not impact your monthly loan payment amounts and also does not call for your interest rate to be adjusted. It’s a great tool to leverage if you have locked in a low interest rate and don’t want to refinance your loan.
What is the Downside of Doing a HELOC?
Home equity line of credit are generally shorter terms with a floating interest rate. What this means is that a bank has agreed to give you a line of credit for 3-5 years, but then after that time period you will need to reinstate the HELOC for another 3-5 years. This isn’t necessarily a bad thing, however, it is worth noting how it impacts the interest rate you’re borrowing against. If your original HELOC was locked in at 4% and rates increase over the next 5 years, you might be locking in a new HELOC at a higher rate. In general, I personally still feel like a HELOC is worth having as a safety net. When comparing it to credit card APR’s, the financing is much more advantageous.
What is a Cash-Out Refinance?
A cash-out refinance is another great option for investors looking to leverage their equity in a home or investment property. This investment option looks a bit different than a HELOC in the fact that you are actually pulling cash out of your paid down principle.
Cash-out refinances are a great tool when you have a mortgage locked into a higher interest rate than the markets current product offering. Take today’s interest rates for example, many are between 2.75%-3.5%. If you have a current mortgage payment on one of your properties that is higher, you can refinance your home to lock in a lower interest rate, which will lower your monthly payments, and then pull out cash to use on another investment or to pay for a wedding, college, etc.
How Much Can You Borrow Using a Cash-Out Refinance?
This is a great question because a lot of individuals think of their home value based on what they originally paid for the property. But guess what, there may be upside you aren’t accounting for. Take for instance today’s housing market. It is no secret that home values have been on the rise. So when you’re looking into a cashing out through refinancing, the bank is going to order an appraisal to see what today’s market value is. If it appraises for higher than you purchased it, this increases the amount you’re able to cash out. In other words, you are going to want to get an understanding of what the market suggests your home is worth and not go off of what you paid for the home. You may just be sitting on a gold mine ;) A general rule of them is the 80% rule.
Example:
Property Purchase Price = $450,000
Remaining Balance to Pay Off = $350,000
Today’s Market Value = $500,000
$500,000 (market value) x 80% = $400,000
$400,000 - $350,000 (remaining balance) = $50,000 (cash out refi amount)
Based on the above example, you have the opportunity to pull out $50,000 without exceeding the 80/20 rule. If you would like to borrow more than $50,000 in this example, you would most likely impact your monthly mortgage payments. (Read why below).
What is the Downside of Doing a Cash-Out Refinance?
One thing you want to be mindful of when looking into a cash-out refinance option is your loan to value ratio. If you have paid down 20% of your loan and would like to use this investment tool, a HELOC may be a better choice. Why you may ask? Well, when you draw funds from your loan by using a cash-out refinance, you would be reducing your loan to value ratio from 80/20 (loan/equity) to say a 90/10. In other words, you would be cashing out 10% of your equity and decreasing the principle amount you have “paid off on the loan” down to 10%. This would then cause your monthly payments to increase because mortgage insurance would need to be added back until you’ve reached a “paid off” amount of 20% again.
However, if you have paid down 30% of your loan, you could cash out 10% and still have 20% of your loan showing as “paid off”. This would then eliminate mortgage insurance from being added back onto your mortgage payments and would be a great option to be able to pull out funds without impact your monthly payments.
The one caveat I would say to this detail is if you are pulling out money to pay down a higher interest rate of debt, say credit card debt at 13%-20%, a cash-out refinance would still be consider a good option even if you feel below the 80/20 loan to value ratio. Why? Well, your mortgage loan (if refinanced within the last year) would most likely be at a 2.5%-4% interest rate. This is MUCH lower than what you would be paying in interest for a credit card, and therefore would save you money in the long run. Ultimately, I would suggest chatting with a lender to walk them through your goal and see what is the best option for you.
What are the Lending Limits for a Cash-Out Refinance or HELOC?
There are many different caveats per individual when looking into financing options. A bank is going to want to understand what type of property you are referring to - Is it a primary residence? Second home? Cabin? Investment Property? (You don’t need to always owner occupy a home you’re wanting to leverage). As well as, what is your credit score. Both of these details play a role in determining what your borrowing power is across all forms of real estate.
Can You Leverage Both a Cash-Out Refi and HELOC at the same time?
I was unaware until last week, that you actually can leverage both a cash-out refinance and HELOC on the same property. (If you missed my IG Live with mortgage lender, Allison Larson of Novus Home Mortgage, be sure to check it out)! The trick to using both on the same loan is that a cash-out refinance needs to be in first lien position. In other words, if you have a HELOC on a property, but not a cash out refi, you would need to remove the HELOC to open up the cash out refi, and then reopen the HELOC.
How Much Are Closing Costs?
When refinancing a home through a cash-out refinance, your title fees are the same as closing a new home loan, you just don’t have the mortgage underwriting fees. With that being said, you can expect approximately 1%-1.5% in closing costs. So if you have a $500,000 property, expect to pay between $5,000-$7,500 for closing costs depending on your title company.
Now you know how I’ve been able to finance my renovations on two properties at the same time, and also some of the pitfalls that come with it. If this is something you are considering for your own renovation projects, make sure to work out all of the details before getting started so there are no surprises! Hopefully these insights will help you find a financing option that works well for both yourself and your lender. Let me know if you have any questions or comments!
Happy investing!
Jen
Investor // Landlord and DIYer // Realtor // Business Consultant // Globe Trotter // Converting Vegan.
