Higher interest rates have changed the game for borrowing against home equity

Borrowing against your home equity

Last year, if you had enough home equity in your home in order to borrow against it, you had a few choices. The most common choice was between a home equity line of credit (HELOC) or a cash out refinance. A common homeowner question was, “which one should I choose when looking to free up home equity?” Let’s dig into the two options and see how the landscape has changed with higher interest rates, when it comes to borrowing against home equity.

HELOC vs. Cash Out Refinance

Both a HELOC and a cash out refinance can solve the issue of getting cash freed up based on your home equity. The first, a HELOC, is a credit line, or loan, that you pay back over time. The second, a cash out refinance, is a new mortgage that replaces your old mortgage for a higher loan amount, allowing you to pocket the difference. So a HELOC is a loan in addition to your mortgage, and a cash out refinance is a new mortgage for a higher amount.

Before January 2022, when interest rates started to creep up and then nearly double (going from 3% to almost 6.5%), the calculus between the two options made it more of a personal choice than a stark financial comparison. But now, things have dramatically changed.

See this video for how you might approach a HELOC vs. Cash Out Refinance decision.

What changed?

High interest rates – currently 6.5% – made it naturally much more expensive to borrow, especially large amounts of money. For example, if you want to get $30,000 out of your home equity, borrowing it though a HELOC at the current 6.5% rate is a much better bet than refinancing your ENTIRE mortgage balance PLUS $30,000 at 6.5%. That is, at least for anyone who has a current mortgage in the under 3.5% range, which has been the norm for the past 12 years.

How stark is the difference in cost between the two options now?

Let’s do a little exercise to illustrate how the game has changed when comparing the two options. Consider someone with a house worth $500,000 who has a $375,000 mortgage balance, and is seven years intoBorrowing against your home equity their mortgage at 3.5% interest rate. Say they want to borrow or free up $30,000. They would be considering either a $30,000 HELOC, to borrow the $30,000, or a cash out refinance that will let them $30,000 out in cash.

We’ll assume that the interest rate for HELOC and Cash Out Refinance are the same, around 6.5%.

So the choice would be between borrowing $30,000 on a HELOC at 6.5%, or doing a cash out refinance for $405,000 ($375,000 remaining loan balance + $30,000).

Cost comparison

(Assumptions: HELOC is a standard 10 year interest only + 20 year interest/principal pay down structure. Cash out refinance is a standard 30 year fixed rate mortgage.)

As you can see, at 5 years, a cash out refinance costs $40k more and at 10 years, it costs $86k more than the HELOC option. The cost is calculated by tallying up all the mortgage payments and HELOC payments over those timeframes.

What about interest payments?

The interest you would pay for five years with the HELOC option (HELOC plus existing mortgage) is $61k, and at 10 years is $113k.

Contrast that with interest payments on the cash out refinance where at 5 years it is $66k in interest, and at 10 years it’s $62k in interest.

Hmm, that’s interesting. With the HELOC option, you’d be paying nearly double the interest at 10 years.

What is the difference in equity that you’d build?

With the HELOC option, you’d have $199k in home equity after five years, and $258k in equity after 10 years.

With the cash out refinance option, you’d have $120k in home equity after five years, and $156K after 10 years.

Building that much more home equity with the HELOC option, and the significant cost savings makes it the clear choice, despite paying more interest at year 10. 

What the underlying dynamics are

Since in the HELOC scenario, we’re assuming that you’ve been in the house already seven years, not only is the owner paying a smaller interest rate on their mortgage balance of $375,000 of 3.5%, but they’re also further along in the loan amortization process, so they’re building equity faster than if they were at the beginning of their mortgage. Here’s a video that explains this phenomenon. When you’re further along in your mortgage, you’re paying down your loan balance faster, building equity at a faster rate.

Other considerations

HELOCs are usually an adjustable rate product, where the interest rate adjusts every year according to the prime rate plus margin. Since it’s impossible to know where interest rates are headed in the future, the five year and ten year calculations are based on today’s interest rate. But it should be noted that when choosing a product, you should keep in mind this difference.

With adjustable rate products, since they are tied to a prime rate, when that rate goes up, your interest rate also goes up. Also, if the rate goes down, your rate also goes down. People who got adjustable mortgages in 2006 when rates were over 6% saw their rates go down over the next few years as rates dropped. Here’s a video explainer I made of how adjustable rates products work.

What would it look like if interest rates hadn’t almost doubled?

If we were doing this exact same comparison a year ago, here’s what the numbers would’ve looked like, if you were comparing the same HELOC to the same Cash Out Refinance as the example above, but both with a 3.5% rate.

You can see that if you were to only look at the amount that you spend, the numbers are similar between a HELOC plus your existing mortgage and a cash out refinance.

But you can still see the ding on your equity from the cash out refinance. Again, the amortization factor of being further down the path with your first mortgage  results in faster equity building.

Why is this analysis important to do in every financing decision?

Most loan officers don’t mention the equity component when discussing loans.

This is because a refinance is more lucrative to a loan officer than a HELOC. It’s a much bigger loan amount, and they get paid on a percentage of the total loan amount.

There are still plenty of times that a cash out refinance makes more sense, but it pays to do the actual analysis and look at the effects over time.

If you have a financing dilemma and want to make sure you’re making the right choice, consider getting a REAFE or a mini-REAFE done. As you can see, the wrong choice can end up costing you thousands in cost, interest or equity.

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