Cash-Out Refinance vs. HELOC: What You Need to Know
Updated: April 5, 2024
Advertising & Editorial Disclosure
Whether you need funds to finance a home renovation, pay off high-interest debts or bolster your retirement fund, tapping into your home equity may be a solid way to accomplish your goals. Two common options you have as a homeowner are cash-out refinance and home equity line of credit (HELOC).
While both cash-out refinances and HELOCs involve leveraging the equity in your home, they serve different needs and come with their own sets of rules. Cash-out refinances offer stability with fixed interest rates and monthly payments, while HELOCs provide the flexibility to borrow only what you need when you need it. Understanding their differences is crucial in determining the best option for your financial objectives.
Cash-Out Refinance vs. HELOC
Building equity in your home is like putting money in a specialized savings account, where every mortgage payment and increase in your home's value contributes to the balance. Essentially, home equity is the difference between your home's current market value and the amount you still owe on your mortgage. You can calculate it by taking the current market value of your home and subtracting the outstanding mortgage balance.
For instance, let's say your home is worth $300,000 and you owe $150,000 on your mortgage. In this scenario, you would have $150,000 in home equity. It's like having a financial cushion that grows over time as you make more mortgage payments and as your property appreciates in value.
Both cash-out refinance and HELOC are popular options for accessing this home equity. They allow you to unlock this built-up value and turn it into usable cash, albeit in different ways and with varying terms. Choosing between the two should be based on your individual financial needs, whether it's undertaking significant home improvements or consolidating high-interest debt.
What Is a Cash-Out Refinance?
A cash-out refinance is a financial strategy that involves taking out a new mortgage that's larger than your existing one. This is primarily aimed at homeowners who have built up significant home equity and want to convert some of that value into liquid cash. It can be useful for various purposes, from debt consolidation to funding major expenses like home renovations.
In a cash-out refinance, you'll replace your current mortgage with a new, larger loan. The difference between your old mortgage balance and the new loan amount is then paid out to you in a lump sum of cash. Essentially, you're borrowing against your home's equity but with the benefit of potentially more favorable loan terms or interest rates than your original mortgage.
What Is a HELOC?
A home equity line of credit (HELOC) is a financial tool that allows homeowners to leverage the equity they've built up in their homes. It gives you a line of credit that you can draw from over a set period, often called the “draw period.” This approach offers flexibility and can help ongoing expenses such as home renovations, medical bills or educational costs.
The mechanics of a HELOC are similar to those of a credit card. You have a credit limit based on your home equity; you can borrow up to that amount during the draw period. Interest is only charged on the amount you've actually borrowed. Once the draw period ends, you'll enter the repayment phase, where you'll start paying back the principal along with any accrued interest.
To qualify for a HELOC, you'll generally need to meet the following criteria:
Learn the Key Differences
While both cash-out refinance and HELOC allow you to tap into your home equity, the similarities largely end there. Understanding the specific differences between them can help you choose the option that aligns best with your financial goals.
Each of these features impacts how you'll manage your loan and what you'll end up paying over time. A fixed interest rate and monthly payment might provide the stability you need, making a cash-out refinance more appealing. On the other hand, if you prefer the flexibility only to borrow what you need when you need it, a HELOC could be a better fit. Keep these differences in mind as you weigh your options.
Pros and Cons of Cash-Out Refinance
While cash-out refinance can provide you with a sizable lump sum and possibly better loan terms, it also means taking on a new mortgage with its own set of obligations. Understanding the specific pros and cons can offer valuable insights into whether this is the right move for your unique financial situation.
Pros and Cons of HELOC
A HELOC provides a revolving credit line, much like a credit card, using your home as collateral. This financial instrument offers certain unique advantages but also has inherent risks that should be carefully weighed.
Cash-Out Refinance vs. HELOC: Which Should You Choose?
When it comes to tapping into your home's equity, you can either choose cash-out refinance or HELOC. While both can provide much-needed cash, each shines in different scenarios, depending on your specific needs, risk tolerance and long-term financial goals. Knowing when to opt for one over the other can profoundly impact your financial well-being.
- Debt consolidation at a lower interest rate: If you have high-interest debts like credit cards and the current mortgage rates are substantially lower, a cash-out refinance can be a smart way to consolidate and pay off those debts. You'll not only simplify your finances by having one monthly payment but also save money over time due to lower interest rates.
- Large-scale home improvements: When you're looking at substantial home improvement projects that require a significant lump sum upfront, a cash-out refinance can be the better option. The fixed rate offers predictability in repayment, making it easier to budget for long-term expenditures.
- Diversifying investments: If you're a seasoned investor and see an investment opportunity that requires a sizable lump sum, a cash-out refinance can provide the funds at a lower interest rate compared to other loan types. However, this move involves considerable risk and should only be undertaken with thorough research and a well-thought-out investment strategy.
- Children’s higher education: If you need to finance your child’s college education and scholarships or federal student loans aren't covering all the costs, a cash-out refinance can offer a more structured, long-term repayment plan. The rates are usually lower than private student loans, providing a more economical option.
- Ongoing medical expenses: If you’re facing recurring medical costs that are hard to quantify upfront, a HELOC offers the flexibility to draw funds as needed. It's more adaptable than a lump sum, allowing you to manage unforeseen expenses more effectively.
- Multi-phase renovation projects: For home renovations that happen in stages, the draw-as-you-go nature of a HELOC can be highly beneficial. You can borrow just what you need for each phase, thus avoiding interest on a large lump sum you’re not yet using.
- Bridging short-term income gaps: If you're transitioning between jobs or waiting for a bonus, a HELOC can serve as a financial bridge. The usually lower initial, interest-only payments can be easier to manage temporarily, before your income stabilizes.
- Variable rate benefits in a falling-rate environment: If you have a good handle on market trends and anticipate a period of falling interest rates, a HELOC could offer short-term cost savings. Keep in mind this strategy carries risk, as rates can go up and down.
A driving force behind your decision here should be current interest rates. If current rates are significantly higher than the rate on your primary mortgage, a cash-out refinance won't make financial sense because you may be hit with a double dose of higher rates over a longer term. HELOCs can be more advantageous, especially when interest rates are high because you can retain the lower rate on your first mortgage while gaining access to a flexible financing tool you can tap into over time. — Timothy Manni, Mortgage and Real Estate Consultant
Frequently Asked Questions
When considering ways to leverage your home equity, it's natural to have questions about whether a cash-out refinance or a HELOC would better suit your needs. To help you navigate this decision, we answered some frequently asked questions that go beyond the basics and offer unique insights.
In a cash-out refinance, your original mortgage is fully paid off and replaced by a new, larger loan. This means you will deal with a new set of terms, possibly including a different interest rate and loan duration. However, the benefit is that you get access to a lump sum of cash that you can use for various purposes.
Yes, you can, but the lender might require a "seasoning" period. This period could be anywhere from six months to a year between your last refinance, and the time you can apply for a HELOC. Keep in mind that the seasoning period can affect the total amount you're eligible to borrow.
In a cash-out refinance, the interest rate is usually fixed, providing predictability in your monthly payments. HELOCs, on the other hand, generally come with a variable interest rate, which means your monthly payments could fluctuate. However, some HELOCs offer a fixed-rate conversion feature, usually at an additional cost.
While a HELOC offers greater flexibility on how you use the funds, cash-out refinances can sometimes have restrictions, especially if they're government-backed loans. For instance, FHA or VA loans may specify the funds be used for home improvements or debt consolidation. Always check with your lender about any limitations on fund usage.
While it's technically possible to opt for both, it's a risky move that could over-leverage your home's equity. Most lenders may be uncomfortable offering both options to the same homeowner. If you're considering this, consult a financial advisor to understand the implications better.
The interest you pay on funds used for home improvements can be tax-deductible for both cash-out refinance and HELOC. However, this typically doesn't apply if you use the money for other purposes like debt consolidation or a vacation. Be sure to consult a tax advisor to understand the specific tax implications for your situation.
Some HELOCs offer the option to convert from a variable to a fixed interest rate. However, this conversion often involves additional fees or a higher interest rate post-conversion. It's essential to read the fine print and understand all the terms before switching.
About Christopher Boston
