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Home Equity Line of Credit vs. Refi: Which Makes More Sense in This Economy?

Tapping your home's equity with a HELOC can be a cost-effective option in today's housing market. Here's what you need to know.

a tiny wooden house sits on top of a jar of pennies
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Homeownership has its benefits. A major one is the ability to grow your wealth by building equity, which is the difference between the balance of your mortgage and your home's appraised value. 

One way to access your home's equity is to sell it. Sure, you'll have cash in your pocket, but you'll also have the dubious -- and stressful -- task of finding another place to live; not an ideal situation to be in amid today's rising home values. If you're not looking to move, you can tap your home's equity through either a cash-out refinance, a reverse mortgage (if you're age 62 or older and have paid off your mortgage), a home equity loan or a home equity line of credit, or HELOC. 

With 30-year fixed mortgage rates around 5%, replacing your current mortgage with a new one through a cash-out refinance may not be the most advantageous option, and a reverse mortgage doesn't apply unless you're age 62 or older. That makes home equity loans, specifically HELOCs, a more popular option in today's economy. Here's what you need to know about HELOCs.

What is a HELOC?

A HELOC is a type of home equity loan that allows homeowners to access their equity in the form of a revolving line of credit. The loan balance is based on the amount of equity available in a home. These loans are divided into two phases: a draw period -- the time when borrowers have access to the funds -- and the repayment period, during which the funds are no longer available. The property secures the loan as collateral so the HELOC becomes a second mortgage. This differs from a cash-out refinance loan, which replaces the current mortgage along with an adjusted interest rate and repayment terms.

Tapping your home's equity with a HELOC can be a more cost-effective option than a cash-out refinance as interest rates continue to rise. In late July, the Federal Reserve raised the federal funds rate to a range of 2.25% to 2.50% in a bid to slow the rising rate of inflation, which is currently at 8.5% for the 12 months ending in July. 

While the increase in the funds rate doesn't always translate to higher mortgage rates (average mortgage rates are trending slightly lower in recent weeks), many homeowners have already refinanced and secured historically low interest rates over the past two years. Refinancing with a cash-out option now would raise a homeowner's current mortgage rate, resulting in more interest over the life of the loan.

How do you qualify for a HELOC?

First, you need to have enough equity in your home. Typically, you can borrow up to 85% of your home's appraised value minus what you still owe on your mortgage or other loans secured by your home. Next, your lender will look at your credit score and history, employment history, monthly income and monthly debts to determine your creditworthiness, which will determine the terms of the HELOC. 

Gabe Clark, vice president of mortgage lending for Guaranteed Rate, told CNET that he finds that some customers prefer a HELOC over a cash-out refinance loan because of their flexibility. Borrowers can use a HELOC at their convenience, pay it off and access the funds again later.

In addition to its flexibility, HELOCs offer the following benefits:

  • HELOCs are revolving accounts, like a credit card. You can access the funds when you need them.
  • Most HELOCs require a credit score of at least 620, but a credit score of 700 or higher is preferred.
  • Loan terms can vary from five to 30 years.
  • The "draw period" is the length of time that funds are available; typically anywhere from five to 10 years. Payments are generally interest-only during the draw period.
  • Once the draw period ends, the funds are no longer available, and the loan must be repaid according to the loan terms.
  • Full-draw HELOCs require the full amount of the selected loan to be used initially. All funds allocated must be used for the intended purpose once the loan is processed. 
  • Interest paid on a HELOC is tax-deductible if the funds are used to purchase, repair or substantially improve the property used to secure the loan.

What's the difference between refinancing a loan and a HELOC?

Refinancing is a common practice, especially when you have the opportunity to lower the interest rate and improve other terms of your mortgage. But due to rising mortgage rates this year, it's not a viable option. Matthew Vernon, head of retail lending for Bank of America, explained that the current economic climate is impacting the demand for HELOCs. "Given the recent rise in interest rates, we are seeing more demand for HELOCs than for cash-out refinancing," he told CNET via email. 

"If you did a cash-out refi right now, the new rate would potentially double, which is not a good outcome for consumers," Jackie Frommer, COO of lending at Figure, said explaining the rising demand for HELOCs. She told CNET that the recent increase in demand is attributable to both low interest rates on current first mortgages and significant home price appreciation. "When interest rates rise, refinancing to pull cash out will cost homeowners more over the life of the loan," Frommer added. That's why HELOCs can be a cost-saving alternative to access your home's equity. Figure is a home equity financing platform that funded a record $325 million in HELOCs in June according to its press release -- a 300% increase in loans over this same period last year.

The following table highlights some of the key differences between a HELOC and and cash-out refinance:

HELOC vs. cash-out refinance


HELOC Cash-out refinance
Impact to original mortgage Original mortgage remains in place, no changes. Attaches as second mortgage, secured by property. Pays off existing mortgage. New loan terms based on available criteria. Becomes the first mortgage, secured by property.
Typical loan terms Draw period from 5-10 years. Repayment period up to 20 years. 15- or 30-year repayment terms.
Payment Interest-only during draw period. Adds new payment on top of mortgage. Replaces current mortgage payment.
Access to funds As needed during the draw period. Full cash-out total is immediately upon closing.

Is a HELOC the right choice for you?

Evaluating whether a HELOC is the right choice will depend on factors specific to your case. However, there are some general rules of thumb to consider:

Pros:

  • A HELOC does not change the terms of your original loan.
  • Funds are available to use at any time needed within the draw period.
  • Repayment during the draw period is typically interest-only, giving borrowers more flexibility with cash-flow management.
  • The equity in your home can be accessed to fund home improvements, invest or make large purchases.
  • The interest rates will be lower than unsecured loans, such as personal loans or credit cards.

Cons:

  • The loan is secured using the home as collateral. Defaulting on a HELOC will put a homeowner at risk of losing their home.
  • The HELOC loan will result in the second payment in addition to the mortgage payment.
  • Many, but not all, HELOCs are variable interest rate loans. Your payment will fluctuate with changes in the Federal Reserve's benchmark rate. This rate can change as often as every six weeks depending on actions taken by the Federal Reserve. 

What are the best practices of managing a HELOC?

HELOCs are best suited for homeowners who need to access the equity in their home to fund such big-ticket items as home renovations, college expenses and debt consolidation.

"Home equity lines of credit [can be the] best option because the rates are low compared to personal loans or credit cards. The HELOC that we offer is a fixed-rate HELOC," said Arun Tripathi, head of new secured lending products at Guaranteed Rate. The annual percentage rate, or APR, for HELOCs from Guaranteed Rate is between 4.25% and 12.25%, based on the borrower's credit profile. The loan amount can range from a minimum of $15,000 to a maximum of $400,000. The maximum draw period is five years.

As with any loan product, it's important to understand the loan terms and how they fit into your goals. Variable rate products may have low, teaser offers. Changes in the economy, however, can affect interest rates and your payment. You should also have a plan for repaying the HELOC during the draw period and once the loan-repayment period begins. HELOCs offer consumers the flexibility to access the value accruing in their home, but should be managed cautiously so as to not put the home at risk.  

The bottom line

A HELOC can be a cost-effective way to access cash given the current interest rates without impacting low rates on existing mortgages. For homeowners looking to fund sound investments, home improvements or big-ticket items, a HELOC is a viable option that should be considered. A HELOC, however, isn't ideal to fund day-to-day expenses or if taken out without a clear plan and ability to repay it. What's more, defaulting on a HELOC can result in the loss of the property used to secure the loan.