Eeny, Meeny, Miny, Moe, Which Cash-Out Option Is Best Way To Go? – NMP Skip to main content

Eeny, Meeny, Miny, Moe, Which Cash-Out Option Is Best Way To Go?

How to sort through the myriad of cash-out products for clients in a rising rate environment

Ralph Mclaughlin
Insider
Ralph Mclaughlin
Eeny, Meeny, Miny, Moe

Two rare things are simultaneously happening in today’s housing market: home prices are climbing rapidly while interest rates tick upward. This is putting existing homeowners — who’ve seen extraordinary gains in home equity over the past two years — in a unique predicament. There’s plenty of equity to tap, but doing so will come at a price not seen since before the pandemic.

In this tricky climate, homeowners need to weigh several factors before they determine the best product for their particular financial circumstances. Let’s dig in to see where loan originators should steer their clients.

Methods of equity access

First, a quick review. There are three traditional options for homeowners to tap equity, plus an increasingly popular but new fourth option: a cash-out refinance, a home equity loan, a home equity line of credit, and an equity share agreement.

With a cash-out refinance, the homeowner essentially trades in their current mortgage for a new mortgage with a new interest rate at a higher balance than what they owe, pocketing the difference in cash.

Or there’s the home equity loan that is a second mortgage for the amount a homeowner would like to cash-out. Like a cash-out refinance, these loans provide homeowners access to a lump sum of cash at a fixed interest rate.

A home equity line of credit, or HELOC, is like a credit card-home equity loan hybrid, where cash is made available to the homeowner through a line of credit that they can draw upon (and pay back) if needed, usually for a 10-year period, during which interest-only payments are made. After the 10 years, the balance is typically amortized into a fixed-rate, 20-year mortgage with principal and interest payments.

Most recent on the home finance scene are home equity sharing agreements. With these types of agreements, the homeowner trades an interest in their home to a third party in exchange for cash. Typically, payments are either zero or much lower than your traditional cash-out products, since the third parties profit from taking a share of your home price appreciation over time.

The pros and cons

But with rising interest rates affecting how much it will cost to tap your equity, how can you know which option is best for your clients? Let’s weigh the pros and cons.

A significant plus for cash-out refis is that homeowners can gain quick access to cash without taking a second lien on their property, meaning one loan and one monthly payment. And, because it modifies the existing mortgage rather than adding a second lien to the property, cash-outs have the lowest interest rate of all three traditional options.

But they are not without their drawbacks. Cash-outs present the homeowner with a new interest rate, which may be significantly higher than the previous rate, especially if they were able to lock in a mortgage during post-pandemic interest-rate lows.

Home equity loans, on the other hand, allow borrowers to keep their existing interest rate for their original mortgage balance, and only apply a new interest rate to the cash they extract. But the con is that borrowers must immediately begin to pay back the loan, which will be at a higher mortgage rate than a cash-out refi.

HELOCs may stand out as the most appealing feature for some borrowers, especially those who do not know what they’ll use the funds for or will not use the funds immediately. Plus, borrowers only have to pay interest on what they use, and they and can pay off the loan at any time.

But with HELOCs, interest rates are often higher than cash-outs or home equity loans. And when the 10-year draw period is up and both principal and interest are due, they are rolled into a fixed-rate, 20-year mortgage and the credit line dries up.

Last, home equity sharing agreements are great for homeowners who need cash but can’t or don’t necessarily want a monthly payment. The con for the consumer’s view, of course, is that the third parties originating these products take a percentage of the interest in the home, and thus capture that exact percentage of its value increase over time, until the home is sold, or the loan paid back.

Eeny, Meeny, Miny, Moe 2

Which loan is right?

Cash-out refis make the most sense for those consumers who think the home they are borrowing from is likely their forever home. The ideal cash-out candidate needs fast access to cash and isn’t too in love with their current mortgage interest rate, willing to trade it in for a new rate in exchange for that cash. For them, the idea of having one loan, rather than a second lien, is worth a higher mortgage balance.

For those taking a home equity loan, their current home is also likely their forever home. But they like their interest rates, and they are only willing to accept a new rate on the cash they are extracting. They also want the flexibility to use the funds however they choose, since interest on home equity loans remain tax deductible, regardless of how the funds are used.

The HELOC borrower thinks it’s possible they may move in 10 years, but in the meantime, they want to do some renovations. They like the flexibility of the line of credit because they don’t know exactly how much money they’ll need, and they aren’t susceptible to rising rates (which would increase the monthly payment on the HELOC).

HELOCs can be especially attractive to homeowners who want to use the funds on home improvements, since it means they can deduct the loan’s interest from their federal taxes. Those considering home renovations can access tools to help them make the best decision to increase their home value.

Apps like the Kukun’s Home Renovation Cost Estimator can evaluate a number of influential factors, including the borrower’s ZIP code and the types of finishes or appliances they’re considering, to determine where the money is best spent.

And finally, the home equity agreement partner is mostly interested in getting quick cash without a monthly payment and either doesn’t care about giving up a share of their home value gains or doesn’t think their home will grow much in value over time. It’s also not a bad option for homeowners who think interest rates are going rise rapidly, since there’s no monthly payment and home value growth tends to moderate as rates rise.

This article was originally published in the NMP Magazine June 2022 issue.
Ralph Mclaughlin
Ralph Mclaughlin

Ralph McLaughlin is the Chief Economist at Kukun, a proptech platform and originator of property data, home valuations, and homeowner investment solutions.

Published on
Jun 16, 2022
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