Refinancing, Cash-Out Refi, or a HELOC?

For many, the first step on the path to homeownership is a mortgage. Indeed, the possibility of purchasing a home in one lump sum might be further off than you wish—which is where a mortgage loan comes in. If you have a fair or better credit score and can pull together a modest down payment—anywhere from 3.5% to 20%, depending on the type of loan—you'll likely be able to secure a mortgage. These loans typically charge fixed interest rates and have long loan terms (often 15 to 30 years), making the payments more manageable by spreading the cost of the home over decades.  

As you pay down your mortgage, you build up equity, which is calculated by subtracting any outstanding loans on the property from your home’s current value. This equity is a valuable asset: Once you've built up enough, you may be able to borrow against it to pursue other goals.

In general, you'll need to maintain equity in your home equal to at least 20% of its market value to take advantage of home lending strategies beyond your original mortgage—the more equity you have, the more you can potentially borrow.  

That said, it's especially important to manage any loan secured by your home carefully, since failure to pay it back won't just affect your finances but could also cause the bank to foreclose on your real estate property.  

Still, if you approach your loan with forethought and a plan for repayment, a home lending strategy could make sense. Here are three ways to potentially boost your finances once you have equity in your home.

When interest rates fall, homeowners with enough equity can often refinance a mortgage loan to help reduce their monthly payment and, potentially, the total cost of their loan.  

Say you purchased your home for $500,000 and your original loan amount was $400,000 at 6% interest, resulting in a monthly payment of $2,398 (not including property taxes or insurance). Five years later, your mortgage balance is down to $375,000 and interest rates have fallen to 5%, so you decide to refinance. The payment on your new loan (at 5%) would be $2,013 a month.  

Be aware that refinancing generally requires you to pay fees and other costs to close the loan, which are rolled into the new mortgage. For refinancing to make sense, you need to remain in your home long enough to recoup these closing costs from the savings on your monthly payment.  

Also, when you take out a new 30-year mortgage, you effectively stretch out your repayment schedule (you've already been paying for five years). This can increase your total borrowing cost.  

Refinancing with a shorter loan—a 25-year mortgage, for example—might be a way to reduce your payment without raising the total cost over the life of the loan. Some investors also refinance for a lower payment and interest rate, but continue paying the larger monthly payment to pay off their mortgage sooner and reduce interest even more.

As you build up significant equity in your home, you may also be able to do what's known as a cash-out refinance (or cash-out refi). This is when you refinance for a larger amount than what you owe on your current mortgage, which allows you to pull out cash for other goals, such as a kitchen remodel or a new roof.  

Let's look at an example. Say the value of your home is $550,000 and you owe $300,000 on your original mortgage. Based on creditworthiness and other factors, your lender approves a cash-out refi loan for $374,000 (68% of your home's value). After paying off your original mortgage, plus additional fees and refinancing costs, you could have approximately $65,000 in cash for renovations or other purposes.  

Keep in mind, you'll now be paying back $374,000, plus interest over the life of your loan.

If refinancing or a cash-out refi doesn't make sense—likely because current rates are higher than what you're already paying—you may want to consider a HELOC. A HELOC is a revolving line of credit, which allows you to withdraw up to a certain approved amount over a period of time—similar to a credit card. You can use it for home improvements, a tax bill, debt consolidation, and other expenses.  
Because this type of borrowing is secured by your home, lenders consider it less risky than a credit card or personal loan (for example) and often offer a lower interest rate.  

Unlike a mortgage, the interest rate on a HELOC is usually a variable rate, adjusting up or down in response to market rates. This means your payment and the total cost of your borrowing may go up, if interest rates climb. Also be advised that during the initial "draw" period (usually the first 10 years) the required monthly payments on most HELOCs only cover the prior month's interest charges. So, you won't make a dent on the loan balance unless you pay more than the interest charges each month.  

Not to be confused with a HELOC is another home lending option, called a home equity loan. This is not a line of credit, but instead allows you to borrow a lump sum against the equity in your home. Home equity loans are sometimes called second mortgages, since the lender is second in line, after your original lender. This loan typically has a fixed rate and a fixed term, much like a traditional mortgage.

If you use the money from a cash-out refi, a HELOC, or a home equity loan for home improvement projects on your primary or second residence, your interest payments may be tax deductible. This is one of the reasons borrowing against your home's equity can be an attractive option. You may also be able to deduct interest on up to $750,000 of mortgage debt, including your first mortgage (whether or not you've refinanced) and home equity borrowing. But you have to be prepared to prove to the IRS that the loan funds were used for qualified home improvement expenses.

Your home isn't just a place to live—it's a financial asset that can work for you. The equity you build in your home can open doors to new opportunities. Just be sure to understand the considerations and risks, as mismanaging these loans could put your home at risk. A trusted financial advisor who understands your situation and goals can help you decide whether a home lending strategy makes sense for you.