Welcome to the Refinance Versus HELOC Throw-down

Great question! Looks like you are looking to get some more money in your pocket, through a new loan. The answer is, you can do both! I’ll assume you own your home and have a mortgage. First, let’s define.

Refinance

This implies that you have already financed your home and you have some sort of mortgage. You will be getting a new mortgage and using the proceeds from that loan to pay off your previous loan. Whatever is left over is money in your pocket.

How does this work? Let’s say you have a home you purchased for $110,000 with $10,000 down and you have $50,000 left to pay off the loan. Your interest rate is 5.5% and you got a 30-year amortization. Your monthly payment is $567.79.

You could refinance that 50k you have left at 3% over 30 years. Doing this, you’ll pay a paltry $210.80 per month.

Or you could take out money. Let’s say your home has now appreciated to $150,000. Your bank will finance up to 80%LTV, so you could get a loan for $120,000 (80% of 150k). Financing this at 3% over 30 years gives you a monthly payment of $505.92, a $50 savings over your previous loan. But wait! There’s more: you just got a check for $70,000!

If you are a homeowner looking to decrease payments, refinancing can be fantastic. Seriously, if you haven’t done this in the last 2 years, at least ask your banker about it.

Upsides

  • Can significantly lower your monthly bills
  • Easy to get right now
  • Tax-free
  • You can do this even with little equity in your house

Downsides

  • Closing costs are usually high, like 1% of the loan
  • You need to get another appraisal, which costs $500 to $1,000
  • Benefits are dependent on how bad was your previous mortgage, meaning you won’t save much if you already had a great mortgage
  • The bank will have a maximum LTV; if you don’t have enough equity, you can’t do it
  • Extends the time you will be paying down your mortgage
  • A big lump sum of money beckons you to make stupid purchases. Make Dr. Equity happy and avoid this

HELOC

This stands for Home Equity Line of Credit. The bank gives you a second loan secured by the equity you have in your home. This mortgage is subordinate to your primary home mortgage (should you have one) and is more risky for the bank. The government doesn’t guarantee these loans either, which increases risk.

You need to have equity in your house for this to work. Let’s say you have the same home and mortgage above. You owe $50,000 and it’s worth $150,000. You have $100,000 in equity. Assuming the appraisal agrees with 150k home value, and your bank will loan you up to 80%LTV, then you can have up to $120,000 in loans out. But, you already owe $50,000 so your maximum line of credit will be 120k – 50k, or $70,000.

You’ll continue to have your primary mortgage for $567.79 (unless your refinance that, which you really should). You’ll now add a new variable-rate loan at let’s say 5% (it’s lower than your mortgage because you got the mortgage way back when interest rates were much higher).

Now, you have what amounts to a cool 70k sitting in the bank, while not paying any interest or taxes, but ready to mobilize at a moment’s notice when that great deal comes up. It’s like a loan that you don’t take out but also like money in the bank, ready for quick use.

Remember, any money you take out on this HELOC will need to be paid back at the current interest rate. Your payments will be interest-only, meaning you just pay interest and the principal stays the same unless you pay it down. This new payment will be in addition to your mortgage payment.

If you are looking to do some home repairs or if you are planning to invest in real estate but don’t have the deal found yet, the HELOC is the one for you.

Upsides

  • You can take out the money instantly whenever you need it
  • You can take out as much as you want (up to the maximum) and at multiple draws
  • It’s easy to pay back when and how you want
  • Tax-free
  • No or low cost to obtain the loan
  • The loan is interest-only, so monthly payments are much lower than a traditional mortgage

Downsides

  • You have to have more equity in the house than the bank’s maximum LTV
  • The interest rates are higher
  • You are taking out another loan you will have to pay back
  • There is usually an annual cost of a couple hundred dollars to keep the HELOC active
  • Every few years, you will need an appraisal
  • You’ll be paying more monthly
  • You have to be diligent in paying down the principal
  • Let me repeat myself: don’t spend that 70k on stupid things
Dr. Equity

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