Homeowners

Cash-Out Refinance vs HELOC: Which Home Loan Will Best Meet Your Needs?

If you need some extra cash for home projects, paying off credit card debt, or just life, you may be able to borrow on some of the equity you’ve built up on your home.

If you’re considering a cash-out refinance vs a home equity loan, such as a home equity line of credit (HELOC), what’s the right move? The answer depends largely on your circumstances.

“Start with your existing mortgage and your reason for borrowing,” said Chip Lupo, an analyst and writer for WalletHub. “The biggest practical question is whether it’s advantageous to replace your entire first mortgage under today’s rates and terms, or whether it makes more sense to leave that mortgage untouched and borrow against your equity separately.”

A cash-out refinance does the former. Meanwhile, a HELOC does the latter. Both allow homeowners to tap into their equity to borrow the money they need. 

While both cash-out refinance and home equity loans will provide more liquidity, the terms and conditions of these options vary. That’s why it’s important to know the difference before you sign on any dotted line.

What is a HELOC?

So, what is a home equity line of credit? The HELOC definition is that it’s a revolving line of credit secured by your home equity. It lets you borrow as needed up to an approved limit.

It is in addition to your existing mortgage and does not replace it or impact your existing mortgage interest rate.

Unlike a lump-sum loan, a HELOC will function more like a credit card in that you can pull money from it over a set time frame (usually somewhere from five to 10 years). Typically, you only pay interest on what you use during the “draw period.”

However, once you reach the “repayment date” for the loan, you can no longer pull money from the HELOC. Instead, you must start paying back the principal loan plus any outstanding interest, usually over 10 to 20 years.

How does a HELOC work?

To get a HELOC, a homeowner typically needs sufficient home equity, an appraisal, a minimum credit score of 640, documented income and employment, and a manageable debt load, although exact standards vary by lender.

Typically, homeowners may be able to borrow up to 85% of the value of their property.

“HELOCs can be a good fit for homeowners who are unsure exactly how much they will need to borrow and those who want funds available for emergencies or expenses over time,” said Lupo.

Keep in mind, however, that HELOCs often have variable interest rates. So, the cost of borrowing and your monthly payment can unexpectedly change.

“The payment can also change sharply when the loan moves from the draw period, where interest-only payments may be available, into the repayment period, when principal and interest must be repaid,” said Lupo. “In addition, a HELOC leaves you managing two housing debts, your original mortgage plus the credit line.”

Still, a HELOC is a viable option if you’re not sure exactly how much you’re going to need.

“It’s built for spending that arrives in pieces: a renovation billed in stages, tuition by semester, or a cushion you want available without paying for it until you use it,” said Raf Howery, CEO and founder of the proptech and data analytics platform Kukun.

With that in mind, it’s also worth mentioning that a home equity loan, such as a second mortgage, may be an option worth exploring for those who prefer a more predictable monthly payment.

“A HELOC suits ongoing or unpredictable costs since you draw funds over time as needed,” said Lupo.

What is a cash-out refinance?

A cash-out refinance replaces your current mortgage with a new, larger mortgage, allowing you to borrow against your home equity. You receive the difference as a lump sum.

But how does a cash-out refinance work and what will you need to qualify?

Homeowners may be eligible to borrow up to 80% of their home’s value. But they’ll need a minimum credit score of 580, at least 20% equity in their properties, and not too much other debt. These loans also typically require an appraisal.

The upside of a cash-out refinance is that you can get a large sum of money all at once. This may be a good option for someone who wants to consolidate debt with a lower interest rate. For example, credit cards often have a significantly higher interest rate than cash-out refinances.

The negative is that you’re starting all over on a new loan. That restarts the clock on your loan.

“A new 30-year loan puts you back at the beginning, where nearly all of your payment is interest again,” said Howery.

Cash-out refinances may make sense when you need a large amount of money at once, have a specific and justifiable use for the funds, want one mortgage payment instead of two, and can improve the terms of your existing mortgage by securing a lower rate or otherwise restructuring the loan. 

What questions should I ask myself when choosing between a cash-out refinance vs HELOC?

If you’re still not sure which way to go, here are some questions that our experts suggest you ask yourself when considering these loan types:

• How much money do I need?
• Do I need a large sum of money now or gradually?
• How much equity do I have? Do I qualify for both options? Which structure best supports my long-term financial goals?
• How do today’s mortgage and HELOC rates compare with the rate on my current mortgage?
• Can I comfortably handle a variable rate and fluctuating payments (i.e. if rates rose two points, could I still make the payment?)? Or, do I value the predictability of a fixed payment?
• How long do I plan to stay in the home?
• Am I fixing a cash-flow problem or a spending problem?

“Those questions get to the heart of the choice,” said Lupo. “The best option depends on the cost of borrowing, access to funds, monthly-payment comfort, eligibility and the effect each option has on your existing mortgage.”  

How to decide which loan is right for you?

It’s important to understand these are not two versions of the same loan. A HELOC adds a separate, revolving debt on top of your existing mortgage. Meanwhile, a cash-out refinance replaces the mortgage with a new loan.

“Both can unlock home equity for home improvements, debt consolidation or other needs, and both put your home up as collateral,” said Lupo.

“Look at the full borrowing structure, including whether you need a lump sum or ongoing access to funds, whether you want to preserve your current mortgage, how predictable you need your payments to be, and whether the borrowing has a clear purpose that justifies the cost and risk,” he said.