Cash-Out Refinance vs. HELOC: Which Makes Sense for You?

Home is where the heart is, but it is also a great financial asset. Once you start making your monthly mortgage payments, you will begin to build home equity that you can tap into for a variety of uses. These funds can open the door to home improvements, debt consolidation, and more! But how exactly can you turn your equity into usable cash?

Two of the most common strategies are a cash-out refinance and a home equity line of credit (HELOC). As a homeowner, it is important to understand each of these options so you can better determine which route makes sense for your unique situation. We will explain the ins and outs of these two different home loans, and which one is right for your financial goals.

Tapping into equity: Cash-out Refinances and HELOCs

In order to borrow against your home, you will need to have built enough equity. Equity is the difference between the value of your home versus how much you currently owe on your mortgage. Here is an example:

• $500,000 home value

• $250,000 mortgage

• 50% loan-to-value (LTV) ratio

In the above scenario, you would have enough equity to be approved for a cash-out refinance or a HELOC. However, you will want to stay under 80% loan to value (LTV), so you do not have to pay for private mortgage insurance (PMI).

What is a cash-out refinance?

A cash-out refinance is a type of refinance that replaces your existing home loan with a new mortgage. Your new home loan will come with a different rate and term, plus a lump sum of funds at closing. Since the purpose of this refinance is to turn your equity into cash, this surplus of money will result in a new loan with a larger balance than your current mortgage.

Cash-out refinance borrower requirements include:

• Current mortgage has met its seasoning requirements

• Minimum of 20% equity in your home (depending on your lender)

• Credit score of 620 or higher

• Debt-to-income (DTI) ratio no higher than 45% (depending on your lender)

With a cash-out refinance, you will have a single mortgage. Your new loan pays off your current mortgage and gives you funds at closing. It can be a great option, especially if current interest rates are lower than your current mortgage. However, you will need to account for closing costs and fees (typically totaling 2% to 5% of your new loan’s balance).

What is a HELOC?

A home equity line of credit (HELOC) is the alternative to refinancing your mortgage to access equity. Unlike other home equity loans, a HELOC is a line of credit that you can withdraw funds from for a predetermined amount of time. (The most common is typically up to 10 years.) You can pull as little or as much cash as you need, then only pay interest on the amount withdrawn.

HELOC borrower requirements include:

• Minimum of 15% to 20% equity in your home (depending on your lender)

• Credit score of 620 or higher

• Debt-to-income (DTI) ratio no higher than 43% to 50% (depending on your lender)

If you are doing a home improvement project that will take months, a HELOC could be a great option because you do not have to take out the funds all at once. It is secured with your property, just like a regular mortgage, and starts with an introductory period in which you only pay for interest owed. After that initial period, your variable interest rate and monthly payments can vary based on the market.

Cash-out refinance versus HELOC breakdown

Let us compare these two home loan options side by side:

Advantages of a cash-out refinance versus HELOC

The advantage of a cash-out refinance is that instead of having a mortgage and a separate line of credit, you only have one loan, making your bills easier to manage. Plus, the interest would most likely be lower than a HELOC. You can also choose between a fixed or adjustable rate. Cash-out refinances are a good option for borrowers who need funds and also want to obtain a lower interest rate or new loan terms. However, you will have to contend with a higher monthly mortgage payment due to the larger principal balance. You will also be paying for interest on the lump sum of cash you received, whether or not you use all of the funds.

On the flip side, HELOCs are advantageous because you get to determine how much money you want to take out of your line of credit. This means you can use the cash as you need it (during the draw period) and then only pay interest on what you withdrew. Closing costs are also generally less with a HELOC. You can even save your receipts and check with your accountant to see if your HELOC interest is tax-deductible. However, you will have to be mindful of how you are using your funds to avoid withdrawing more than you need (or can pay back).

Which option is best for you?

Every homeowner’s situation and financial goals are unique, so what works for someone else may not be the right choice for you.

If you get a cash-out refinance, you will be increasing the balance of your home loan. That means it will probably take you longer to pay it off. However, you will have a hand in determining your new mortgage’s loan terms and the type of rate you want. You may even find that interest rates are lower for cash-out refinances than HELOCs, though they have higher closing costs. However, a HELOC will give you the freedom to take out money as you need it, rather than taking on a new, larger mortgage.

At the end of the day, it is best to consult with a trusted lender who can walk you through both processes. You can give them detailed insight into your needs and overall goals to help determine what options will benefit you the most.