One of the primary reasons to consider buying a home is the nature of investing. As you make monthly mortgage payments, you build more equity in the property. Eventually, this equity can be leveraged to improve your financial situation.
Two options you have to take advantage of the equity in your home are a cash-out refinance and a home equity line of credit. A cash-out refinance is essentially a new loan on your home that allows you to get cash based on your current equity. A home equity line of credit (HELOC) is a revolving credit line. These two options have distinct structures, interest rates, repayment methods, and risks.
In this guide, we will compare the two options to help you decide which is best for leveraging the equity in your home, whether you are paying for renovations or consolidating debt.
Cash-Out Refinance and HELOC: A Quick Side-by-Side Comparison
A cash-out refinance and a home equity line of credit allow you access to money quickly based on your home equity. With a cash-out refinance, you take out a new mortgage that is greater than the remaining balance on your original loan, accepting the difference as a lump sum of cash. A HELOC is a revolving line of credit that you can borrow from with a maximum limit.
The interest rates also vary for these products. Most homeowners will seek fixed interest rates on refinanced loans for consistent payments. With a home equity line of credit, you typically have variable interest rates that are based on the market. You pay for a cash-out refinance as you would a typical mortgage, with predictable monthly payments. Under a HELOC, there is a borrowing period followed by a repayment period.
Each method will also have some closing costs. The average closing costs for a cash-out refinance fall between 2% and 6% of the new loan amount. Closing costs for a home equity line of credit typically range from 2% to 5% of the credit line amount.
Understanding Cash-Out Refinancing
A cash-out refinance replaces your original loan on the house. It is a larger loan than the amount you currently owe on your first loan’s balance. You receive the difference in cash. This new mortgage may have a different interest rate, term length, and mortgage payment than the first.
What Happens During a Cash-Out Refinance?
Let’s look at an example for a cash-out refinance. Perhaps you own a home that is worth $200,000, and your current loan balance is $100,000. Most lenders allow you to borrow up to 80% of the home’s market value, which would be $160,000. Now subtract your current loan balance from that maximum amount, and you get $60,000. If you were to apply for a cash-out refinance loan of $160,000, you would receive that $60,000 in cash, minus any closing costs.
Advantages and Disadvantages of Cash-Out Refinancing
Cash-out refinancing comes with numerous benefits and disadvantages. Typically, you can secure a fixed-rate loan, ensuring your monthly payments remain consistent. Mortgage rates are also lower for refinancing than for personal loans.
However, since you are taking out a new loan, you restart the mortgage clock. It will also increase your total debt amount.
What Is a HELOC and How Does It Work?
A home equity line of credit is similar to a credit card. A credit limit is established based on your current equity in the home. You can then borrow money from that credit line for a certain amount of time, making interest-only payments during the draw period. Eventually, you will enter the repayment period and must begin paying back the interest and balance.
How Borrowing With a HELOC Is Structured
The draw period for a home equity line of credit is typically five to ten years. During this time, you only have to make payments on interest. However, you can also pay back some of the principal to continue borrowing in the future.
Once the repayment period hits, this can last ten to twenty years. During this time, you must make regular payments on the interest and principal, and you can no longer borrow money from the credit line. Often, people open up HELOCs to borrow money for home improvements.
Pros and Cons of Using a HELOC
A HELOC provides greater flexibility because you can borrow the money that you need when you need it, up to a certain amount. If the market is favorable, you could also take advantage of a lower interest rate, even if that rate may shift in the future.
Some of the disadvantages of a HELOC include variable interest rates, the risk of overspending, and the added burden of an additional lien on your property. If you cannot manage the monthly payments after the draw period ends, you may face severe financial consequences.
Which Option Typically Has Better Interest Rates?
Replacing your existing mortgage with a cash-out refinance typically has a favorable interest rate compared to a HELOC or a home equity loan. The main benefit is the fixed rate you can access when refinancing, whereas a credit line is at the mercy of the market interest rates.
Your interest rate will depend on several factors, including the loan-to-value ratio, your credit history, and whether the loan has a fixed or variable structure.
Comparing Repayment Terms and Flexibility
The repayment structure for a cash-out refinance will be similar to your current mortgage. You will have monthly payments that cover portions of interest and principal. For a HELOC, the draw period only requires interest payments. Once the repayment period begins, it will function much like your existing mortgage, with regular payments.
One thing to consider about HELOCs is the potential for payment shock. Without adequate planning, you may be faced with larger-than-expected payments when the repayment period begins, so it is essential to be prepared for this stage.
Fees, Closing Costs, and Ongoing Charges
Since a refinance loan is typically a larger amount, the closing costs can be more expensive. These expenses will include appraisal fees, origination fees, and other related costs. A HELOC will be less expensive upfront, but the penalties for early closure are pretty steep. Also, HELOCs often have annual maintenance fees, whereas the majority of the costs for a cash-out refinance are covered upfront.
Borrowing Limits: How Much Equity Can You Access?
Both investment options will be affected by borrowing limits. Typically, lenders and credit unions will have maximum loan-to-value ratios of 80%. You will probably never find a financial institution that will let you borrow 100% of a home’s value. LTV is calculated by dividing the loan amount by the home's current market value.
Ultimately, your borrowing power is determined by the home's value, the current mortgage balance, the minimum credit score, and the lender’s policies.
Tax Deduction Rules and Equity Loans
In both cases, interest on your payments can be tax-deductible. However, the money you received from the refinance or HELOC must be used for capital improvements on the property to be tax-deductible. For example, if you receive a lump sum payment after replacing your original mortgage and you use that money to remodel the kitchen, the interest payments on your new loan should be tax-deductible.
Best Option for Home Repairs or Renovations
Both a cash-out refinance and a HELOC can be effective options for homeowners looking to improve their properties. If you have a large, one-time project, a cash-out refinance is a better option. For smaller projects or those with multiple phases, a HELOC may be a better option because it involves ongoing borrowing.
Is Home Equity a Good Tool for Debt Consolidation?
Many homeowners will use their equity to consolidate debt. Often, these debts have much higher interest rates, especially student loans and credit cards. The methods mentioned in this guide can help you pay off these higher-interest debts, though you will be converting unsecured debt into secured debt that is tied to your home.
What Credit Score Do You Need for a HELOC or Cash-Out Refinance?
Cash-out refinancing typically has a higher threshold for the minimum credit score, often requiring a credit score of at least 650 to be considered. You may also need a maximum debt-to-income ratio of 45%.
On the other hand, a HELOC can be accessible with a credit score of 620 and a maximum DTI of 50% with many lenders. It all depends on which firm you choose and your financial situation. Refinance loans typically take one to two months before you receive funds, while HELOCs can be opened in two to six weeks.
What Are the Potential Risks to Keep in Mind?
You should never make major financial decisions without assessing the risks. For example, foreclosure could disrupt your homeownership after refinancing because you reset the mortgage clock and are unable to manage the payments for an extended period. Rising interest rates in the market could make the repayment period for a HELOC extremely unpredictable. There is also the risk of borrowing more money than you need, which can result in higher minimum payments.
Deciding Which Equity Option Fits Your Situation
Each option can work well for your financial needs as long as you understand the terms well. For a larger one-time expense, refinancing is a better option because of more competitive interest rates and consistent payments. Paying off smaller debts or tackling ongoing home improvement projects are better suited for a HELOC due to its ongoing borrowing period and repayment flexibility.
FAQs About Cash-Out Refi and HELOCs
Should I use a HELOC or a cash-out refi for home upgrades?
It depends on the extent and timeline of the project. If you are investing in a single large renovation, such as a new roof or a remodeled kitchen, a lump sum payment from a cash-out refinance makes more sense. However, if your improvement project has multiple stages or you have several small projects planned over several years, a HELOC can be a more effective option.
Are VA or FHA loans compatible with cash-out or HELOC options?
Government loans are often compatible with refinancing or HELOC options, but borrowers typically must meet specific terms. VA loans may offer more favorable mortgage rates, but their closing costs are steeper due to the VA funding fee. FHA loans may have stricter standards for occupancy when refinancing or obtaining a HELOC, but the credit score requirements are more lenient.
Does using home equity affect my credit score?
Opening a credit line or taking out a new loan will always affect your credit score due to the credit checks. However, if you have a strong score and make your payments on time, the drop in your score will be quickly wiped away.
