HELOC Vs. Cash-Out Refi: Pros, Cons And Which Is Better For You
So, you’re ready to get some of that sweet equity out of your home. Excellent! One of the reasons for buying a home instead of renting is to build equity, so why not cash out, right? Plans to tap your equity have probably invoked questions about closing costs, interest rates, refinancing, and a second mortgage.
At the top of your list may be how to weigh a home equity line of credit (HELOC) vs. a cash-out refinance. Fear not; here are all the ins and outs and factors to consider so you can make the best decision for your unique situation.
Cash-Out Refinance Vs. HELOC: Definitions
Cash-out refinances and HELOCs are financial instruments that turn your equity into cash. The following is a deep dive into the definitions and uses of each.
A cash-out refinance is a mortgage refinance that a homeowner can use to reconfigure their current mortgage loan and turn equity into cash. The refinance does away with the old mortgage and gives the homeowner a new mortgage with a higher loan amount. The increase comes from the equity the homeowner withdraws as cash. You can use the money received from a cash-out refinance for any purpose.
Home equity is your home’s value compared to your mortgage balance. For example, if you owe $100,000 on your mortgage and your home is worth $250,000, you have $150,000 of equity. Generally, cash-out refinances allow you to turn 80% of your equity into cash (except for VA loans, with which you can access 100% of your equity). So, you could use a cash-out refinance to gain up to $120,000 and replace your mortgage with one that accounts for the amount of equity you tapped.
Lenders use three primary criteria to determine eligibility for cash-out refinances:
- Home equity: You can’t refinance with meager equity, and lenders look for homebuyers to have 15% – 20% equity remaining after the refinance.
- Debt-to-income (DTI) ratio: Your debt-to-income (DTI) ratio is your monthly income versus your monthly minimum debt payments. To qualify for a cash-out refinance, your DTI can be a maximum of 50%.
- Credit score: Usually, your credit score must be 620 or higher to qualify for a cash-out refinance. However, if your refinance is a VA loan and you access 90% or less of your equity, you can qualify with a score of 580. Likewise, if Rocket Mortgage® currently services your home loan, you can turn equity into cash with an FHA loan and a median score of 580 if you use the money to pay off debt.
A cash-out refinance features the main benefits of home equity loans plus several distinctive advantages.
The first significant advantage is you’ll only have one mortgage for your house. As a result, your lender has first payback priority since you don’t have a second mortgage to pay like you would with a home equity loan.
Another upside is low interest rates, which reduce your monthly payment and make your mortgage cheaper in the long run. A lower interest rate puts more money in your pocket each month for other expenses.
Cash-out refinances are also usually the best way to consolidate debt because they’re based on your primary mortgage, so you’re getting the lowest possible mortgage rate for your financial profile. Replacing high-interest credit card debt with mortgage debt is a financial win because you exchange exorbitant interest rates for your mortgage rate.
Lastly, if you use the cash-out refinance to improve your home, your mortgage interest might be tax-deductible.
Cash-out refinances also have drawbacks. For example, your lender will require you to leave a minimum amount of equity within the home. Therefore, the part of your equity that’s accessible may be inadequate for accomplishing your goals, causing you to seek forms of debt that can satisfy your needs but have higher interest rates.
In addition, the interest rate on your refinanced mortgage will reflect the current economy. For instance, if you bought your house when interest rates were low, a refinance might double your interest rate. In that case, leaving your mortgage as is and taking out a second mortgage through a home equity loan might be more financially sound.
Finally, cash-out refinances have closing costs of 2% – 6% of the loan amount you pay up front or roll into the loan.
Home Equity Line Of Credit
A home equity line of credit (HELOC) turns your equity into a revolving line of credit, meaning you can borrow against your equity at will instead of receiving a one-time lump sum. You can think of a HELOC as your equity transforming into a credit card you can access during a specified timespan (known as the draw period), typically lasting 5 – 10 years.
During the draw period, you’ll pay minimum or interest-only monthly payments on any debt you’ve incurred. When the draw period expires, the repayment period begins, in which you have 10 – 20 years to repay the whole balance.
HELOC Vs. Home Equity Loan
The differences between a HELOC and a home equity loan are significant. Here’s what you should know if you’re trying to decide between two:
HELOCs and home equity loans provide borrowers with distinctive interest rate packages. Specifically, home equity loans typically have fixed rates, while HELOCs have variable interest rates.
A fixed rate is permanent throughout the loan, giving borrowers the stability of a guaranteed monthly payment amount. On the other hand, variable interest rates change periodically according to broad economic conditions. As a result, your variable interest rate could raise or lower your HELOC payments substantially, and it’s wise to budget for higher interest payments in case your interest rate rises.
Monthly payments create a stark contrast between HELOCs and home equity loans. During the draw period of your HELOC, you’ll pay interest on what you borrow. This dynamic gives you initially low monthly payments compared to a home equity loan. Conversely, since a home equity loan is a second mortgage, it requires monthly payments plus interest shortly after you receive the loan.
In addition, payments throughout the HELOC can vary because of the adjustable interest rates. For example, a rate that adjusts quarterly will change your monthly payment amount four times per year. Conversely, home equity loans usually have fixed rates, so the payment doesn’t change.
Homeowners access their equity differently with home equity loans and HELOCs. For instance, if you take a home equity loan, you’ll receive your money as a lump sum. On the other hand, a HELOC gives you 5 – 10 years to draw on your equity numerous times and in any amount.
For example, your HELOC might change $50,000 of your equity into a line of credit for 5 years. In the 1st year, you withdraw $5,000 to improve your home. Then, in the 5th year, you withdraw $10,000 to consolidate high-interest debt. Afterward, you would owe $15,000 during the repayment period.
Home equity loans last 5 – 30 years. However, HELOCs usually last 30 years: first is the 10-year draw period, followed by a 20-year repayment period.
As with a cash-out refinance, your lender will hold financial standards to your application for a HELOC:
- You generally must have more than 15% equity in your home based on its current value.
- Your debt-to-income (DTI) ratio usually has to be less than 43%.
- Your credit score should be 620 or higher, with better scores helping you obtain better interest rates.
HELOCs grant homeowners numerous advantages. For example, you can use the funds withdrawn for any purpose. Additionally, your interest payments are tax-deductible if you use the HELOC money for improvements or additions to your home.
HELOCs also give you more control over your equity so that you only borrow what you need. Borrowing as you go can leave you with a lower total debt than a home equity loan, which comes to you in one lump sum.
Repayment for HELOCs is also less stringent because the first 5 – 10 years require interest payments only. This feature lowers expenses during the first part of the loan.
HELOCs aren’t suitable for every situation because of certain pitfalls. First, since it turns your equity into a revolving line of credit, a HELOC makes less sense if you have a sole, giant expense you can’t afford. A home equity loan or cash-out refinance can give you the lump sum needed.
Also, your lender might stipulate specific minimum withdrawals during the draw period, forcing you to borrow more money than you need. Expenses of a HELOC increase further because of closing costs, maintenance fees, early payoff fees, inactivity fees, and transaction fees.
Another issue to remember with HELOCs is the variable interest rate. The adjustments might raise your interest rate and make your monthly payments expensive. In other words, the unpredictability of a variable interest rate can wreak havoc on your budget.
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HELOC Vs. Cash-Out Refi: The Similarities
Although HELOCs and cash-out refis have key differences, they share numerous similarities, such as:
- Because HELOCs and cash-out refis use your equity, you risk foreclosure if you can’t afford payments on them.
- Your interest is tax-deductible if you use the funds for home improvements or additions.
- Both require you to leave 10% – 20% of your equity untouched.
- You’ll pay closing costs based on the total loan amount.
- You can use funds in any way you wish.
- You’ll likely receive a lower interest rate than a personal loan or credit card.
- Lenders have similar DTI and credit requirements for both, although cash-out refis give more flexibility with VA loans.
HELOC Vs. Cash-Out Refi: The Differences
Here is how HELOCs and cash-out refis diverge:
- Cash-out refis usually have a fixed interest rate, while HELOCs have variable rates.
- You’ll receive a lump sum from a cash-out refinance instead of a line of credit you can access for several years.
- If you refinance with a VA or FHA loan, your lender will likely have lower financial requirements than a HELOC.
- A VA cash-out refinance may give you access to 100% of your equity.
- You’ll have one mortgage after your cash-out refi, while a HELOC will create a line of credit you’re responsible for, plus your existing mortgage.
- A cash-out refinance might have higher closing costs than a HELOC, but you can also roll them into your new loan amount if necessary.
How To Choose Between A Cash-Out Refinance And HELOC
If you’re stuck in your choice between using a cash-out refinance or HELOC to access your equity, consider the following factors:
- Loan terms vary between the two. A cash-out refinance pays off your existing mortgage and gives you a new one with new terms. On the other hand, a HELOC doesn’t change your current mortgage and comes with its own timeframe. Typically, you have 10 years to draw funds and 20 years to repay your balance.
- Interest rates are usually fixed for cash-out refinances. As a result, your monthly payment never changes, and the tradeoff is your interest rate can’t adjust to the market if interest rates dip. Conversely, HELOCs have variable interest rates, meaning your rate will fluctuate during repayment, possibly rising and making your monthly payments more expensive. If you fall behind on unexpectedly high payments, you risk foreclosure.
- Closing costs for a cash-out refinance are usually slightly higher than HELOCs, but you can roll them into the new mortgage.
- Funding comes to you in a single lump sum through a cash-out refinance. On the flip side, HELOCs allow you to access a specific amount of equity over several years, meaning you can withdraw money periodically based on your needs.
Choosing A Cash-Out Refinance
Choosing a cash-out refinance is best when you benefit from the interest rate and have one planned expense. Note that your refinance interest rate doesn’t have to be lower than your original mortgage to be helpful, depending on your circumstances.
For example, let’s say you have $10,000 of credit card debt with a 20% interest rate and a $10,000 auto loan with an 8% interest rate. A cash-out refinance with a 6% interest rate will allow you to pay off your debts and leave you with a new mortgage that is $20,000 higher than before (plus closing costs) with an interest rate of 6%. Your monthly payment for your new mortgage will be significantly less expensive than paying on your original loan plus your high-interest debts.
Choosing A HELOC
A HELOC can help you tackle multiple expenses over an extended period. For instance, you might have three home improvement projects to complete over the next 10 years. However, you only have ballpark figures for the expenses of each one, and you plan on doing one job at a time. You figure the projects will take no more than $50,000 combined, and you have plenty of equity to cover these expenses.
You can take one project at a time and pay only what’s necessary with a HELOC with a ten-year draw period. You’ll access your equity as a revolving line of credit for each project instead of sitting on a lump sum you need to start repaying immediately. At the end of the draw period, you’ll only pay for the funds used.
The Bottom Line
Cash-out refinances and HELOCs both allow you to turn your equity into cash for any financial needs. In addition, both have similar financial requirements and provide tax deductions if you use the funds for home improvements.
However, crucial differences separate the situations in which these financial tools are helpful. Specifically, cash-out refinances are best for large, singular expenses and can provide excellent interest rates. On the other hand, HELOCs transform equity into revolving credit you can access repeatedly. Plus, they have variable interest rates that correlate with market trends, possibly destabilizing your monthly payments.
Your equity is a powerful financial tool that can help you get ahead. If you’re interested in using a cash-out refi, start your application online today.