If you need funds for home improvements or repairs, to banish expensive credit cards, or for another worthwhile purpose and are wondering which one is better—a home equity line of credit or a cash-out refinance—you’ve come to the right place. Both financial moves let you tap into your home’s equity without putting it up for sale, which is why HELOC and cash-out refinancing are two popular options to acquire cash.
Both a home equity line of credit and a refinance are less risky for the lender because your house is the collateral. Consequently, you may get lower interest rates compared to personal loans and other unsecured loans, and probably much lower rates than you could get with a credit card. However, in case you default or miss your payments, the creditor has every right to foreclose on your property, which can result in your losing the house.
Although both financing options might sound similar and come under the same category, HELOC and cash-out refinancing are quite different. Keep reading to learn the pros and cons of these popular homeowner options: HELOC versus refi.
What Is a HELOC?
Commonly called HELOC, a home equity line of credit is a way of borrowing a small or large sum of money against the equity of your house at a pace that suits you. Similar to a credit card, a HELOC is an additional loan that you will need to pay back, with interest. A HELOC does not replace your mortgage.Free Loan Quotes
Because this is a line of credit, not a lump sum, the lender will provide access to the cash, but you will only be charged interest when you decide to spend it. The creditor will also set a spending limit according to your credit score and home equity. Most lenders will provide you with paper checks or a credit card that can be used to access the line of credit during a certain period (draw period). This can last 5 to 10 years.
While you can make interest-only payments on the money spent during the draw period, as soon as the duration ends you enter a 10- to 20-year repayment period, wherein you must pay back the principal plus interest.
When Should You Consider a HELOC?
A HELOC is usually preferred over a cash-out refinance by borrowers who don’t desire to live in the house for long and want to use the money as needed over time. Consider signing up for a HELOC in the following situations.
- You do not require all the money now but plan to use the loan over the draw period.
- You plan to reside in the house long enough to take advantage of the HELOC but probably not long enough to repay a 15-year cash-out refinance.
- You have the means to make two monthly payments: one on the HELOC and one on the mortgage.
- You don’t have a problem with variable interest rates.
- You want interest-only payments on the amount you spend, not on the whole loan amount.
What Is Cash-Out Refinancing?
Cash-out refinancing refers to taking out a new mortgage large enough that you can pay off the existing mortgage and keep the remainder as cash. The amount that you can cash out depends on your home’s value and your equity.
Like other mortgages, the cash-out refinance mortgage will have single monthly payments, a loan term, and a fixed interest rate, which will likely differ from the previous mortgage.
When Should You Consider a Cash-Out Refinance?
As with a HELOC, you’ll pay closing costs when you take on a cash-out refinance. The new mortgage replaces your old one. Whether you should choose a cash-out refinance, therefore, has a lot to do with whether the new mortgage has better terms than the old one.
In the following circumstances, it’s worth considering a cash-out refinance.
- Interest rates have plummeted or your credit score has soared, and now you could get a really low rate to replace the old one.
- Your current mortgage has an adjustable rate and you fear big increases on the horizon.
- You want a lump sum of cash in a few weeks.
- You can afford a higher mortgage payment.
- You plan to live in your house until the mortgage term ends.
- You want to deduct all interest that you are paying on the mortgage.
The Pros and Cons of HELOC vs. Refinance
Here are the pros and cons of a HELOC versus a cash-out refinance.
|Can borrow approximately 85% of your equity||Variable interest rates|
|Lower interest with a high borrowing limit||Creditors charge appraisal fees, application fees, and closing costs|
|You can pay interest-only on the money used during the draw period||You can only access the line of credit during the draw period|
|You can use the money for anything you like||It can reduce your home equity|
|If you spend the money on home repairs, the interest could be tax deductible||You will have this payment in addition to your mortgage|
|Freedom to use the cash however you like||Complex loan rate and terms|
|Fixed interest rate||Higher underwriting standards|
|Interest is tax-deductible||More interest to pay because the loan is larger|
|You receive the money up front||Cannot access additional funds without refinancing|
|One monthly payment||Equity is lowered more than with a HELOC|
|You might get a tax break if you use the money for home renovation or remodeling||Your house will be held as collateral|
Key Differences Between a Cash-Out Refinance and a HELOC
Below are the major differences and similarities of these two popular financing options that leverage your home equity.
|Loan Type||Primary mortgage||Second mortgage|
|Features||A new loan with adjustable or fixed interest rate;
A one-time cash payment
|A credit line with varying interest rates;
Revolving credit line
|Loan Term||It can match the years left on your old mortgage, be shorter, or be up to 30 years||10, 20, or 30 years, depending on the lender’s terms|
|Equity Requirement||20% if incurs, less mortgage insurance||15% to 20%|
|Maximum Loan Amount||80%||80% to 85%|
|Repayment Structure||Principal payments;
|During the draw period, you’re charged interest only on the money you spend;
After that, you must pay back the principal plus interest
|Closing Fees & Costs||2% to 5% of the principal||Closing costs are sometimes less compared to refinancing;
Costs may be waived if you meet various restrictions
Pros and Cons of HELOC vs. Refinance: Frequently Asked Questions (FAQs)
Now that you know the pros and cons of HELOC versus cash-out refinancing, let’s answer some frequently asked questions.
Q: Which is easier to qualify for, a HELOC or a cash-out refi?
Compared to HELOC, qualifying for a cash-out refinance mortgage is easier. This is because refinancing replaces the primary mortgage, giving the creditor first position. HELOCs, in contrast, are considered second mortgages—another loan layered atop the existing home loan.
Tip: Shop around and select the loan with the best interest rate and favorable terms.
Q: How much can I borrow?
Whether you are opting for a HELOC or a cash-out refinance, the loan amount depends on the following factors.
- Credit score
- Home equity amount
- Loan-to-value ratio
- Debt-to-income ratio
Regardless of the type of loan you opt for, it will not be equal to the cost of your property. In fact, the loan amount can never exceed 90% of the house’s value.
Q: Are the proceeds of a HELOC and a cash-out refinance taxable?
While home equity is taxable as a type of profit, you’re taxed on this capital gain only when you sell the house. The money you get from a HELOC or a cash-out refinance is not taxable because they’re both loans; you must pay the money back.
Q: When do I have to pay back the loan?
According to HELOC policy, the borrower is not compelled to make principal payments during the draw period, which is usually 5-10 years. You can pay interest-only on the money as you spend it. After the draw period you enter the repayment period, which can last 20 years. In this period, you pay back the principal plus interest.
Like the primary mortgage, cash-out refinances can span up to 30 years, though it’s highly recommended to match the years left on your old mortgage so you’re not moving backward. When people opt for a cash-out refinance, they can keep their original end date, shave off some years, or add years. Each decision will affect the payment amount and the total interest paid at the end.
Q: Is the interest rate eligible for tax deduction?
So long as you use the line of credit for home improvement, the interest paid on a HELOC is tax-deductible. Conversely, because a refinance is considered a first-lien mortgage, interest is only deductible on the first $750,000 of the loan.
HELOC vs. Refinance: Which Is Better?
While HELOCs come with lower upfront costs and give you a period in which you can make interest-only payments if you wish, a cash-out refinance is easier to qualify for and has a fixed interest rate. Furthermore, a HELOC is better if you want access to large funds but won’t spend it all at once. With a HELOC, you’re only charged interest on the money as you use it, and you can make interest-only payments, if you wish, during the draw period.
On the flipside, a cash-out refinance is a wise choice if you require a lump sum quickly. For example, you might need to make the down payment on a second house, or those high credit card fees are killing your budget and you want to pay off the accounts. Additionally, with a fixed annual percentage rate (APR), you can enjoy predictable monthly payments over the mortgage period.
Both a HELOC and a cash-out refinance can help property owners by converting home equity into cash. Get rates from different lenders and decide which one is right for you based on the terms, loan period, home equity, the duration you plan to reside in the house, and how you will use the money.Free Loan Quotes