Homeowners who want to exchange some of their home equity for cash have a few options: refinance their mortgage with a bigger loan (cash-out refinancing), or leave their existing mortgage alone and add a second mortgage -- a home equity loan or home equity line of credit. They can even choose to refinance their first mortgage and then add a second mortgage. Which option is better? It depends on several factors. Homeowners first need to answer a few easy questions:
1. How wll the loan proceeds be used?
Cash-out refinance or home equity loan proceeds can be used for almost anything -- but different loans are better suited for some uses. For example, a self-employed borrower who wants a source of emergency cash is probably better off with a home equity line of credit (HELOC), because the money isn't needed yet (and may never be needed). A HELOC is very cheap to set up and the homeowner won't have to pay interest until / unless he or she actually uses it. HELOCs are also ideal for paying college tuition every year, for ongoing home improvement projects or anything that requires flexibility. The lump sum generated by a home equity loan or cash out refinance, however, is better for things like debt consolidation or a big-ticket purchase.
If the loan's purpose can best be met with a line of credit, that eliminates cash-out refinancing as a source of funds. In that case, the best choice is a HELOC.
2. Can the homeowner improve on the terms of the existing mortgage?
Home equity lines can often be set up for free, and home equity loans cost much less to set up than rate-and-term or cash-out refinances. Unless the homeowner can get refinance offers that are significantly better than the existing home loan, taking a second mortgage (either home equity loan or line of credit) is a smarter choice.
You should compare current refinance rates and offers to help you decide. If available interest rates are higher than what the homeowner is already paying, there is no reason to refinance the existing home loan. Consumers should proceed with a home equity loan or line of credit. If available rates are better, though, there are a few more considerations.
3. What's better -- the blended rate or the refinance rate?
If refinancing the existing mortgage hasn't been eliminated by the answers to the first two questions, it's time to do some calculations. The homeowner has three choices:
- Take a cash-out refinance
- Refinance the first mortgage and add a home equity loan
- Leave the first mortgage alone and add a home equity loan
What makes this somewhat complicated is the fact that cash-out refinancing almost always costs more than rate-and-term refinancing. To correctly compare all three options, the homeowner must determine the blended rate for each choice.
Calculating a blended rate is pretty easy. Of course, the cash-out refinance rate is easy to figure out. Just grab the APR from the loan offer. If the homeowner owes $200,000 on a $300,000 property and wants to borrow an extra $25,000, he or she needs to get the cash-out refinance rate, the "regular", or rate-and-term refinance rate, and the home equity loan rate. Here are the inputs:
- Current mortgage rate: 4.25 percent
- Rate and Term rate: 3.958 percent
- Cash-out rate: 3.979 percent
- Home equity rate: 6.59 percent
Here's the blended rate calculation for refinancing the first mortgage and then adding a home equity loan:
- Divide the $200,000 rate-and-term refinance amount by the total borrowed. That's $200,000 / $225,000, which is .8889.
- Multiply the result by the rate-and-term refinance rate. .8889 * 3.958 = 3.518 percent.
- Divide the $25,000 cash needed by the total borrowed. $25,000 / $225,000 = .1111
- Multiply the result by the home equity rate. .1111 * 6.59 percent = .732 percent.
- Add both figures together to calculate a weighted average. 3.518 percent + .732 percent = 4.25 percent.
- Use our home equity calculator for a quick calculation
Keeping the current mortgage with its 4.25 percent rate and adding the home equity loan has a higher blended rate of 4.510 percent, so in this case the cash-out refinance is the better deal. In general, the more cash desired, the more likely it is that the cash-out refinance is the better loan.