When comparing a cash-out refinance vs HELOC, it’s essential to know that these are two popular ways to convert some of the value of your home into spendable cash. Understanding how they work and what each does best will help you choose the right option for your needs.
What Is Home Equity?
Before discussing cash-out refinancing vs HELOCs, it’s important to understand what home equity is.
Home equity is the value of your home minus the outstanding balance of any debts secured by that home.
If you have a home worth $250,000 and a $200,000 mortgage, you have $50,000 in equity in that property.
Remember that home equity is based on the current value of your home, not the amount you paid for it. If property values in your area have increased, your home equity may be higher than you realize.
Knowing how much equity you have in your home is the first step in using any credit product based on home equity.
Lenders won’t let you borrow up to 100% of your home’s value. Depending on the type of loan you use, you’ll need to maintain a certain minimum amount of equity. That’s why understanding equity is key. The more you have, the more cash you can get out of your home.
There are advantages and risks that go with all methods of borrowing against home equity. Because the loan is secured by your home, interest rates are usually low, and approval is relatively easy.
Also, because the loan is secured by your home, you could lose your home if you can’t pay the loan. Never borrow more than you can afford to pay back, and be sure you have a realistic payment strategy in place.
What Is a Cash-Out Refinance?
A cash-out refinance relies on refinancing your existing mortgage.
When you refinance a loan, you apply for a new loan and use the proceeds to pay off the existing one. That lets you adjust the details of a loan, such as by changing its interest rate or adjusting the repayment term. For example, if you refinance a loan to a lower rate or a longer term, you can lower its monthly payment.
With a cash-out refinance, you refinance your mortgage but take out a new mortgage for an amount greater than you currently owe. You can then pocket the difference as a lump sum in cash and use those funds for other purposes.
Imagine you own a home worth $500,000 with a remaining mortgage balance of $250,000. You do a cash-out refinance, getting a new mortgage for $350,000. You use that money to pay off your loan and have $100,000 left over for other purposes.
You can’t cash out all of your home equity. Most lenders will require that you maintain 20% equity in your home. So, in the example above, you couldn’t get a new mortgage for more than $400,000.
📚 Learn more: In case you’re considering options to utilize your home’s equity, our latest vlog post sheds light on the pros and cons of Home Equity Loan Vs. Cash-Out Refinance.
Pros and Cons of Cash-Out Refinancing
Cash-out refinancing has a number of advantages, but it’s also important to consider the drawbacks.
- Single monthly payment. You’re taking money out of your home by refinancing your existing mortgage rather than taking on an additional loan. That means you only have one monthly payment to make rather than needing to pay your mortgage plus a second loan.
- Long terms. Cash-out refinance loans are very similar to a mortgage used to buy a home. That means you can extend the repayment term to up to 30 years.
- Fixed rates. When comparing cash-out refinance vs HELOC, one distinction is that you can opt for a cash-out refinance loan with a fixed interest rate. This makes the monthly payment more predictable than a HELOC, which comes with a variable rate.
- Low rates. Mortgages consistently have the lowest interest rates of all loan types. Your rate will probably be well below what you would pay on a personal loan.
- Give up your existing mortgage. A cash-out refinance replaces your existing mortgage with a new one. That may not be desirable, depending on the details of your current loan. For example, if you are locked in at a low-interest rate, refinancing may mean accepting a higher interest rate, increasing the cost of your loan.
- Fees. You’ll have to pay closing costs and other fees on your refinance loan. Depending on the size of your loan, that could mean paying thousands in fees.
- Equity requirements. Most lenders won’t let you use a cash-out refinance to borrow more than 80% of your home’s equity. That means you’ll need far more than 20% equity in your home to be able to get a meaningful amount from cash-out refinancing.
You’ll need to balance the pros against the cons and decide whether a cash-out refinance is worth it.
What Is a Home Equity Line of Credit?
A home equity line of credit (HELOC) is a revolving line of credit that is secured by your home equity. In many ways, it works like a credit card.
When you open a HELOC, you’re given a credit limit. You can draw funds from the HELOC when you need to and can draw funds from the line multiple times until you reach the credit limit. You only pay interest on the outstanding balance of the HELOC.
Typically, a HELOC comes with a draw period and a repayment period. You can take funds from the line of credit during the draw period. Each month, you’ll get a bill to pay the accrued interest. You can choose to also pay down the principal, but you aren’t obligated to.
Once the draw period ends, repayment begins. At this point, you cannot draw more money from the line of credit. You’ll need to begin making payments that cover both accrued interest and a portion of the principal.
HELOCs have slightly less stringent equity requirements than cash-out refinances. Some lenders will give you credit limits that will result in you having just 10% or 15% equity in your home.
Pros and Cons of Home Equity Lines of Credit
Home equity lines of credit are highly flexible, but it’s important to consider the disadvantages before opening one.
- Borrow more. A major difference between cash-out refinance vs HELOC is that HELOC lenders often let you borrow more from your equity than you’d be able to borrow with a cash-out refinance.
- Flexibility. For the length of your HELOC’s draw period, you can pull funds from the line of credit. That makes it a quick and easy way to get extra cash when you need it, giving you financial flexibility.
- Only pay interest on the outstanding balance. With a cash-out refinance, you pay interest on the full balance starting immediately. With a HELOC, you only pay interest on the funds you’ve drawn.
- Variable interest rates. Most HELOCs have variable interest rates. That means that rates can change based on movements in the interest rate market. If rates go up, you could see your monthly payment rise.
- Two monthly payments. A HELOC is an additional loan against your home. That means that you’ll have to make two payments each month. One toward your primary mortgage and one toward your HELOC.
- Shorter term. HELOCs usually have a five- or ten-year draw period, followed by a repayment period of ten or twenty years. That shorter term compared to cash-out refinancing could mean higher monthly payments.
- Overborrowing risk. During the draw period, you may be tempted to draw more money than you need, which may make payment more challenging.
A HELOC can be an effective way to finance a project with an uncertain cost, like a home repair or renovation, but you have to resist the temptation to borrow more than you need.
Cash-out Refinance vs HELOC
When it comes to understanding the difference between cash-out refinance vs HELOC, it’s essential to know that they are similar in many ways, but there are a few key differences. For example, both rely on the value of your home to determine how much you can borrow, but one offers a lump sum of cash while the other is more flexible.
|Cash Out Refinance
|Lump sum of cash upfront
|A lump sum of cash upfront
|Must retain 20% equity
|Must retain 10% – 15% equity
|Usually fixed rate
|Usually variable rate
|Single monthly payment
|Two monthly payments
|Repayment period up to 30 years
|Repayment period up to 20 years
|Change details of your primary mortgage
|Keep your primary mortgage
When comparing cash-out refinance vs HELOC, generally, you’d opt for a cash-out refinance for one-time expenses and a HELOC for more flexibility.
When to Consider a Cash-Out Refinance
A cash-out refinance gives you a single lump sum of cash all in one go. That makes them a natural fit for one-time expenses or projects where you know how much you’ll need to spend.
If you’re renovating your kitchen and the contractor told you that the price is $25,000, using a cash-out refinance to take $25,000 out of your home makes sense. The expense is predictable, and the loan will cover that expense.
A cash-out refinance can also be a cost-effective way to generate funds for debt consolidation, especially if you have large amounts of high-interest debt.
If you’re planning to rely on the funds for multiple projects or aren’t sure how much money you need, a cash-out refinance might not be the best idea since you’ll either need to borrow more upfront and pay unnecessary interest or wind up under borrowing.
It’s also important to think about the terms of your mortgage compared to current mortgages. For example, if you have a mortgage with a fixed rate of 3% and new mortgages are charging twice that, giving up the low rate is probably a bad idea, even if you need a lump sum loan. In that case, it’s better to consider alternatives.
When to Consider a Home Equity Line of Credit
HELOCs are the better option when you value flexibility or know that you’ll need access to financing but aren’t completely sure how much you’ll need to borrow.
With a HELOC, you’re free to draw money from the line of credit multiple times. You also won’t pay interest on the unused line of credit. That means you can open the line of credit and make an initial draw to start a project, then pull more funds as needed while limiting the amount of interest you have to pay.
A HELOC is also a good option if you have a good deal on your existing mortgage and don’t want to give it up. You can keep your existing loan while using a HELOC to tap your equity.
However, if you’d prefer getting a lump sum of cash, as you would with a cash-out refinance, you could also consider a home equity loan. That would let you get a lump sum at a fixed rate without changing your existing mortgage.