When is a Cash-Out Refinance Better than a HELOC

When is a cash-out refinance better than a HELOC?

Whether you need extra money to make home improvements, consolidate debt, or start an emergency fund, tapping the equity in your home is an easy way to generate cash flow. With fluctuating interest rates, varying loan terms, and repayment periods, it can be tricky to choose the right loan. Here are some instances when opting for a cash-out refinance makes more financial sense than applying for a home equity line of credit (HELOC).

Tapping into your home equity

Home equity is simply the difference between how much your home is currently worth and the amount you still owe on your mortgage. The equity in your home fluctuates over time as you make monthly mortgage payments and when the market shifts. 

If the remaining balance on your mortgage is lower than the current value of your home, you may be able to borrow against your home and use the money to fund things like home improvement projects, debt consolidation, and even pay back student loans.

Using the value of your home to begin home improvement projects and pay back debts can be a wise financial choice because equity loan interest rates are usually lower than those of credit cards and personal loans. Home improvement projects may be tax deductible when utilizing the funds to boost home value. Consult a tax adviser for further information regarding the deductibility of interest and charges.

While both a cash-out refinance and a home equity line of credit (HELOC) are two of the most popular loan choices when it comes to accessing the equity in your home, there are some instances when a cash-out refinance may be the better option.

What is a HELOC?

A home equity line of credit (HELOC) is a type of second mortgage that lets you borrow against your home and turns the equity into useable cash. It functions like a credit card allowing access to funds as needed. Interest charges and penalties are not applied to unused funds, giving maximum flexibility to finance large home improvement projects or emergency expenses.

A HELOC is a second mortgage, which means a new loan is added to your property. Now, you will pay two loans at the same time. Keep in mind, there are two different periods for borrowing and repayment on this loan. During the "draw period" your line of credit is available to use and payments only need to be made on the interest owed. After this period ends (typically five to ten years), monthly payments are required on the total amount borrowed.

What is a cash-out refinance?

A cash-out refinance is a type of refinancing that provides you with a larger mortgage in exchange for tapping your equity. This new loan replaces the existing loan, and in exchange you receive a check. The new mortgage will have a higher loan amount at the same term, or extended term. However, it is necessary to reapply and go through the mortgage process again because a cash-out refinance is a primary loan.

Key differences between a cash-out refinance and a HELOC

It is hard to understand the differences between a cash-out refinance and a HELOC. Here is a breakdown of some of the pros and cons of each loan to determine which is best for your financial situation.

Cash-Out Refinance

• Primary loan where you must reapply
• Loan term may change
• Could potentially lower the interest rate depending on market conditions
• Monthly payments may increase or decrease
• Offers fixed interest rates (if obtaining a fixed-rate loan)
• Offers fixed monthly payments (if obtaining a fixed-rate loan)

Home Equity Line of Credit (HELOC)

• Adds a second loan
• Your current loan stays the same, and you borrow only from the available equity
• Offers variable or fluctuating interest rates determined by the current market
• Offers interest-only payments during the draw period
• When the repayment period begins, you must pay the principal balance of the loan, plus interest

Reasons to opt for a cash-out refinance

While both loans can give you access to the equity in your home, there are some situations when a cash-out refinance is the better option. Here is a list of instances when choosing a cash-out refinance makes the most financial sense. 

1. When it lowers your interest rate

When interest rates are low, applying for a cash-out refinance is a good idea. You will receive a check to pay for expenses and lower the interest rate on your mortgage simultaneously. However, when mortgage interest rates rise, HELOCs become more popular as you can tap your equity while the rate and term on your existing loan remain unchanged. 

2. When you want to lower your monthly payment

Achieving lower monthly mortgage payments is possible with a cash-out refinance when you extend the repayment term on your new loan. By opting for a 30-year fixed-rate mortgage you will receive cash and lower your monthly payments. Keep in mind, this option accrues more interest over the life of the loan.

3. When you want to pay off your house sooner

Alternatively, a cash-out refinance can be used to switch to a shorter loan term, such as a 15-year fixed-rate mortgage. This adjustment shaves ten years off your repayment schedule and lowers the interest accrued over the life of the loan. 

4. When the interest rate is lower than a personal loan or HELOC

Even if you don't plan to adjust your monthly payments or pay off your house sooner, a cash-out refinance may still make sense if it provides a larger loan and a lower interest rate than a personal loan or HELOC. Keep in mind that if moving forward with a cash-out refinance, the entire balance will be subject to that new interest rate. Depending on what you choose to purchase with the extra funds, you might even qualify for tax breaks on closing costs (consult a tax advisor for more information).

When determining which loan is best for you, understanding your financial goals is critical. Consider a cash-out refinance if you want extra cash while paying off your house sooner or lowering your monthly payments and interest rate. Contact your loan originator to help crunch the numbers and find the best loan option.

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