You’ve built up a significant amount of home equity and want to convert it into cash. Two common options are cash-out refinances and home equity lines of credit. Both can be appealing, but it’s worth understanding the differences between the two to decide which is best for your financial situation.
What is Cash Out Refinance?
A cash-out refinance lets you swap out your current mortgage for a new, larger one, typically with different terms. The difference between the two loans is the amount of equity you pull out, and it’s disbursed shortly after closing.
Most lenders let you pull out 80% of your home value. To illustrate, if you owe $275,000 on your home and it’s worth $425,000, you could access up to $65,000 ($425,000 * .80 minus $275,000).
If you decide to move forward, the new lender will pay off your existing mortgage of $275,000 at closing. You will also get $65,000 and a new mortgage of $340,000 ($275,000 + $65,000).
Key Features
- Interest rates: Cash-out refinances come with fixed interest rates, giving a set monthly principal and interest payment over the life of the loan.
- Closing costs: Expect to pay between 2% and 6% of the loan amount in closing costs to seal the deal.
- Monthly payments: You’ll get a single monthly mortgage payment since you’re essentially swapping out one loan for another.
Benefits
- There are no spending restrictions on funds received through a cash-out refinance.
- Cash-out refinances often come with lower interest rates compared to credit cards and personal loans.
- You can use the funds to consolidate high-interest debts and save a bundle in borrowing costs over time.
- If you use the funds to make home upgrades or repairs, your home’s value could increase.
What is a HELOC (Home Equity Line of Credit)?
A home equity line of credit that also lets you tap into your home equity. But you won’t have to refinance, as it acts like a second mortgage with features similar to a credit card.
You get a revolving line to pull from as needed during the draw period, which typically lasts between 10 and 15 years and is followed by a repayment period of 10 to 20 years.
Most lenders let you borrow up to 85% of your home equity.
Key Features
- Interest rates: HELOCs usually come with variable interest rates that change with market conditions.
- Closing costs: Most borrowers pay between 2% and 5% of the loan amount in closing costs.
- Monthly payments: You’ll typically make interest-only payments during the draw period, followed by principal and interest payments over a 10 to 20-year period.
Benefits
- You don’t have to refinance your current loan to tap into home equity.
- Loan payments are lower during the draw period.
- You can control borrowing costs by only withdrawing what you need.
Key Differences Between Cash-Out Refinance vs HELOC
When deciding between a cash-out refinance and a HELOC, here are some key differences to be aware of.
Purpose and Usage
- Cash-out refinance: most ideal for major expenses, like home renovations, or to consolidate high-interest debt
- HELOC: commonly used for ongoing or recurring expenses or as an emergency fund
Impact on Home Equity
- Cash-out refinance: lowers your home equity right away
- HELOC: only impacts your home equity as you draw funds
Loan Structure
- Cash-out refinance: new mortgage payable in equal monthly installments over a set period
- HELOC: revolving line of credit that doesn’t affect your current mortgage
Interest Rates
- Cash-out refinance: typically comes with a fixed interest rate
- HELOC: variable interest rates that could increase over time are common
Costs and Fees
- Cash-out refinance: closing costs payable before the transaction is finalized
- HELOC: closing costs along with annual fees and withdrawal fees with some lenders
Loan Amounts and Limits
- Cash-out refinance: capped at 80% of your home’s value
- HELOC: limited to 85% of the equity you have in your home
Payment Structures
- Cash-out refinance: fixed monthly principal and interest payments over the loan term
- HELOC: interest-only payments during the draw period, followed by principal and interest payments payments that vary during the repayment period
Loan Durations/Repayment Terms
- Cash-out refinance: 15 and 30-year terms are most common
- HELOC: 10 to 15-year draw period, followed by 10- to 20-year repayment term
Tax Implications
- Cash-out refinance: a portion of the interest paid may be tax-deductible if the funds are used to cover home improvements
- HELOC: similarly features the benefit of tax-deductible interest with qualifying home improvement expenditures
When to Choose a Cash-Out Refinance
Below is a closer look at why a cash-out refinance could be a better fit than a HELOC.
Large Expenses or Consolidating Debt
Are you planning to cover a major expense and have a concrete idea of how much funding you need? Whether you want to pay for a major home renovation, cover higher education costs (i.e., tuition fees), handle hefty medical bills or start a business, a cash-out refinance can provide the funding you need to meet your goal.
Some homeowners also cash out refinances to consolidate high-interest debt and make the balances more manageable. Instead of paying several creditors each month, you get a single monthly payment. And if you’re able to secure a lower interest rate than you’re currently paying, you can potentially save a bundle in interest.
Long-Term Financial Planning
Have mortgage rates dropped since you initially took out your mortgage? Or maybe your credit rating has improved, and you qualify for a better rate? Either way, a cash-out refinance could get you a better rate that’s fixed and access to cash.
Unlike a HELOC with a variable rate, a fixed rate means you get a set monthly mortgage payment (principal and interest) that’s easier to budget for. Predictability is particularly important if you’re planning for retirement or other long-term financial goals.
When to Choose HELOC
Some circumstances also warrant the selection of a HELOC over a cash-out refinance.
Ongoing or Unpredictable Expenses
When life happens, you could face financial strain if you don’t have the funds accessible to get over the hump. But with a HELOC, you get peace of mind knowing there’s a pool of cash to draw from as needed when you incur unpredictable expenses.
The same applies to ongoing expenses that you anticipate incurring for an extended period. This is common if you plan to renovate your home or make extensive repairs that will take some time.
Short-Term Financial Needs
HELOCs also offer a solution when you need quick access to funds for whatever reason. You can borrow quickly and easily at any time during the draw period without having to finance your mortgage.
Plus, you’ll typically get a lower interest rate on a HELOC compared to traditional loan products designed to meet short-term financial needs. And with an extended repayment period, you have more time to repay what you borrow, giving you more affordable monthly payments than standard emergency loans.
Conclusion: Final Tips for Making a Decision Between Cash-Out Refinance vs HELOC
To decide which option is best to leverage your home equity, evaluate your finances along with the borrowing costs. It’s equally important to speak with a financial advisor and scope out lenders to make an informed decision.
Assess Your Financial Situation
Start by evaluating your current financial health. Take a look at your income, expenses, current debt load and savings to determine if you have the means to take on additional debt. More specifically, you want to ensure you have enough wiggle room in your budget to avoid the new monthly mortgage or HELOC payment.
Calculate Total Costs
Compute the costs of taking out a cash-out refinance and a HELOC. Ideally, you want to select the option with benefits that outweigh the costs.
Consult with Financial Advisors
Speak to a financial advisor for additional guidance. They can help you further compare cash-out refinances and HELOCs, run different scenarios to gauge how each could affect you financially and provide insight regarding potential tax consequences of both options. Consulting with a financial advisor also equips you with the knowledge needed to make an informed decision.
Compare Multiple Lenders
Shop around and compare quotes from various lenders, including traditional banks and online lenders. Pay attention to interest rates, loan terms, fees and reviews from both current and past customers to get an idea of what to expect.
