Is a Cash-Out Refinance, Home Equity Loan, or HELOC the Better Way to Access Your Home Equity?

U.S. home equity is near an all-time high. According to the St. Louis Federal Reserve, U.S. homeowners have nearly $30 trillion in home equity, which is just below the peak in 2022.

Using your home equity can be a good way to pay for home renovations or repairs. It can also be a smart way to pay off high-interest credit card debt, pay for college, or fund other large purchases. But unless you plan on selling your home, there are three main ways to tap into your home equity -- through a cash-out refinancing, a home equity loan, or a home equity line of credit (HELOC). Here's an overview of the pros and cons of each option.

Cash-out refinancing

A cash-out refinancing was the clear best option when mortgage rates were in the 3% ballpark. Not only could you tap into your home equity, but in most cases you could lower your mortgage interest rate in the process. Now, refinancing activity has ground to a halt, and it's easy to understand why.

The average 30-year fixed mortgage interest rate is approaching 8%. Refinancing replaces your entire mortgage with a new one, and since the bulk of U.S. homeowners have mortgage rates well below 5%, this isn't a desirable option in the current environment in most cases.

Think of it this way. Let's say that you have a mortgage with a $300,000 remaining balance and 20 years remaining on its repayment term, and your interest rate is 4%. Your monthly principal and interest payment is $1,818.

Now, let's say that you want to use $75,000 of your equity to fund a renovation project. You could obtain a new 30-year mortgage for $375,000 at an 8% APR. This would not only increase your monthly payment to $2,752, but it would also add 10 years to your repayment term. It's tough to make the numbers make good financial sense.

The biggest advantage to a cash-out refinancing in the current economic climate is that it's usually the easiest of the three options to get approved for. A cash-out refinance is a primary mortgage loan, so it represents less of a risk to the lender than a home equity loan or HELOC, which are secondary liens. In other words, if you can't pay your HELOC, your primary mortgage lender has first claim to the property in the event of foreclosure.

Home equity loans and HELOCs

In the vast majority of cases, home equity loans and HELOCs are the best ways to tap into your home equity in the current interest rate environment. To be sure, rates on these instruments are likely to be even higher than cash-out refinancing rates. In fact, I recently filled out a pre-approval for a home equity loan just to see what I'd get, and the best APR I was offered was about 10%.

However, you're only paying the higher rate on the equity you're tapping into. In the previous example, you'd keep your $300,000 primary mortgage at 4% interest, and would take out a second loan with a higher rate, but only on $75,000 of principal. And although home equity borrowing rates are much higher than they were a year or two ago, it can still be a much lower rate than you'll find with a personal loan and can be the best option to fund a large expense.

There are a couple of key differences between home equity loans and HELOCs to know. Home equity loans are generally fixed-rate loans with a set monthly payment and term. And they work much like a personal loan, in the sense that the entire amount is disbursed to you upon closing. On the other hand, a HELOC is a credit line from which you can draw (or not draw) funds up to a certain amount. You'll only pay interest on the money you choose to draw from the HELOC, and these typically have a variable interest rate that will go up and down over time. HELOCs are often the best choice if you want the ability (but not the obligation) to use your home equity as needed.

The bottom line

Tapping into your home equity can be a smart way to pay for large expenses -- especially renovations and repairs that will increase the value of your home. This is even true given the rapid rise in interest rates in recent years.

However, the cash-out refinancing loan as a way to tap into home equity has lost its appeal, with home equity loans and HELOCs emerging as the smart ways to go, assuming your primary mortgage has a sub-5% interest rate like most in the U.S. do. If you think using your home equity is the best way to access the capital you need, a good next step is to compare some of the top home equity lenders to see which might be the best fit for you.