In a Nutshell
A HELOC and cash-out refinance are two different ways to tap equity that you have in your home. Here's what to know about how they work and when to consider one over the other.If you own your home and have built enough equity in it, there are different ways you can access that equity.
Two potential options are a cash-out refinance and a home equity line of credit (HELOC).
A cash-out refinance is a new mortgage loan that replaces your current one for more than you owe, giving you access to your home’s equity in cash. A HELOC, on the other hand, is a line of credit that you can draw from, similar to a credit card, using your home as collateral.
Here are things to consider before you make a decision.
- What is the difference between a HELOC and cash-out refinance?
- How to compare a HELOC and a cash-out refinance
- How does a HELOC or cash-our refi affect my taxes?
- Is it better to have a HELOC or refinance?
- What are my other options to use my home equity?
- FAQs about HELOCs and cash-out refinances
What is the difference between a HELOC and cash-out refinance?
As you compare a HELOC to a cash-out refinance, you’ll notice several key differences in how they work.
How a HELOC works
A HELOC is a form of revolving credit that functions much like a credit card. Rather than giving you an upfront, lump-sum payment of your equity, a HELOC gives you a credit line that you can borrow against, pay off and repeat the process.
For example, let’s say you take out a HELOC for $100,000. You can borrow against that amount at any point during the HELOC’s draw period, and you’ll typically make minimum or interest-only payments on the amount that you borrow during that time.
Once the draw period is over, your HELOC enters a repayment period, at which point you’ll need to make regular monthly payments to pay off your remaining balance. Draws may no longer be allowed during this period.
HELOCs are typically harder to qualify for than cash-out refinance loans because a HELOC is a subordinate or second mortgage loan. This means that if you default on your payments and your home is foreclosed on, your primary mortgage lender gets the first claim on the proceeds of the foreclosure sale.
How a cash-out refinance works
A cash-out refinance is a new mortgage loan that replaces your current mortgage loan for more than you owe. In addition to the amount needed to pay off your existing mortgage loan, the lender will also give you cash.
Cash-out refi amounts may be limited to a certain percentage of the home’s appraised value — often 80% of your loan-to-value ratio.
For example, if you owe $200,000 on a home whose estimated worth is $400,000 and want to borrow $100,000 from your home equity, you’d apply for a $300,000 mortgage. If approved, you’d receive $100,000 in cash upon closing the loan.
You’ll then pay that balance over a set repayment period, just like you were doing with your original mortgage.
How to compare a HELOC and cash-out refinance
| HELOC | Cash-out refinance | |
|---|---|---|
| Loan terms | HELOC has a draw period and a repayment period. During the draw period, you can take withdrawals from the line of credit and pay them back over time as long as you don’t exceed your credit limit. | Cash-out refinance functions like a traditional mortgage loan. You’ll choose your repayment term — often 30 years or 15 years — and make installment payments throughout that period. |
| Interest rates | HELOC interest rates are typically variable, which means that they can go up or down over time along with market rates. | With a cash-out refinance, you may be able to choose a fixed interest rate or an adjustable interest rate. |
| Funds availability | A HELOC gives you a line of credit that you can draw upon and pay off repeatedly throughout your draw period. | With a cash-out refinance, you’ll receive the full amount upfront when your loan closes. |
| Closing costs | For HELOCs that have closing costs, lenders typically charge between 2% and 5% of the credit limit. But you can get a HELOC without any closing costs. Keep in mind that some HELOCs charge annual fees. | When you take out a cash-out refinance loan, you’re paying closing costs on the full principal balance, not just the amount you’re taking from your equity. These costs typically range from 2% to 5% of the loan balance. |
Loan terms
With a HELOC, there’s a draw period and a repayment period. During the draw period, you can take withdrawals from the line of credit and pay them back over time as long as you don’t exceed your credit limit.
You typically only have to make minimum or interest-only payments during this time, but once the draw period is over, your remaining balance will be amortized over the repayment period, which can last as long as 20 years — and you’ll make monthly installment payments until it’s paid in full.
In contrast, a cash-out refinance functions like a traditional mortgage loan. You’ll choose your repayment term — often 30 years or 15 years — and make installment payments throughout that period.
Interest rates
HELOC interest rates are typically variable, which means that they can go up or down over time along with market rates. If market conditions cause interest rates to go up, your HELOC may get more expensive over time. But the opposite may also be true if market rates go down.
In some cases, HELOCs may allow you to convert some or all of your balance to a fixed-rate loan that you can pay off over a set period.
With a cash-out refinance, you may be able to choose a fixed interest rate or an adjustable interest rate. If you opt for an adjustable-rate loan (ARM), your interest rate will be fixed for the first three to 10 years, after which it will switch to a variable rate and fluctuate based on market conditions.
Availability of funds
A HELOC gives you a line of credit that you can draw upon and pay off repeatedly throughout your draw period. If you don’t need all of the money at once, that can be an advantage.
You can typically access funds from your line of credit via a bank transfer, debit card or paper check.
With a cash-out refinance, you’ll receive the full amount upfront when your loan closes. You’ll typically get the funds in the form of a check or a wire transfer.
Closing costs
For HELOCs that have closing costs, lenders typically charge between 2% and 5% of the credit limit. But in many cases, you can get a HELOC without any closing costs at all. Keep in mind that some HELOCs charge annual fees.
In contrast, when you take out a cash-out refinance loan, you’re paying closing costs on the full principal balance, not just the amount you’re taking from your equity. These costs typically range from 2% to 5% of the loan balance.
How does a HELOC or cash-out refi affect my taxes?
Because a cash-out refinance is a primary mortgage loan, the interest you pay on the loan may be tax deductible on the first $750,000 you borrow. In contrast, you may only be allowed to deduct interest paid on a HELOC if you’re using that line of credit to buy, build or substantially improve the property you’re using as collateral.
In other words, if you’re considering a cash-out refinance or HELOC for debt consolidation, college expenses, emergency needs or anything that’s not related to the home, the interest paid may be deductible on the cash-out refinance but may not on the HELOC.
Consult with a tax professional to learn what may be permitted in the current tax year.
Is it better to have a HELOC or refinance?
When to consider a cash-out refinance
Because the upfront cost of a cash-out refinance can be higher than a HELOC, you’ll want to think about the pros and cons of applying for a cash-out refi.
Consider whether …
- Your credit has improved, or market rates have gone down, and you can get a better interest rate on the new loan than what you’re paying now.
- You want all of the money upfront and don’t need long-term access to a credit line.
- You only want one monthly payment to worry about.
- You’d prefer a fixed interest rate instead of dealing with rate fluctuations.
- You plan to live in the home long enough to recover the loan’s closing costs.
- Your budget can afford the higher monthly payment.
- You want to be able to deduct all of the interest that you’re paying on your loan. Closing costs tend to be lower with a HELOC than with a mortgage.
When to consider a HELOC
A HELOC may also be worthwhile if you plan to stay in your home for several years. You may not be able to take full advantage of the line of credit if you sell the home and move before your draw period ends.
On the other hand, a HELOC may be preferable to a cash-out refinance if you’re not planning to stay in the home for the long run.
With that in mind, here are some situations where it might be better to choose a HELOC over a cash-out refinance.
- You don’t need the full amount upfront but want the flexibility to access your equity at different times over the HELOC’s draw period.
- You’re not sure you’ll need all of the funds, and you only want to pay interest on the amount you’ll actually use.
- You’re not concerned about a variable rate.
- You’re OK with making two monthly payments: one for your primary mortgage loan and another for your HELOC.
- You plan to live in the home long enough to take full advantage of the HELOC.
What are my other options to use my home equity?
There are other ways to tap into your home equity, including home equity loans and reverse mortgages.
Home equity loans
A home equity loan is a type of second mortgage that allows you to borrow against the value of your home. You receive the money as a lump sum and repay it over a fixed term at a fixed interest rate. This can be a good option if you need a large amount of money for a specific purpose, like a home renovation or to consolidate high-interest debt. But it comes with a risk to consider: If you can’t repay your loan as agreed, the lender could foreclose on your home.
Reverse mortgages
A reverse mortgage is a loan that allows homeowners age 62 and older to convert part of their home equity into cash. Unlike a traditional home equity loan or second mortgage, you don’t have to repay the loan until the home is sold or no longer your primary residence. But with a reverse mortgage, failing to meet the ongoing loan requirements can result in default, potentially leading to foreclosure.
What’s next
As you determine whether it’s a good idea to borrow from your home’s equity, you’ll want to as yourself these questions:
- How long do you plan on living in the home, and is it long enough to make the HELOC or cash-out refinance worth it?
- Is your credit good enough that you can qualify for a low interest rate?
- What are the current interest rates?
- How much equity do you currently have in your home, and is it enough to achieve your goals?
- How much money do you need to borrow?
- Can you afford to pay the closing costs and the additional monthly payment?
- Are you concerned about foreclosure if you can’t keep up with your monthly payments?
FAQs about HELOCs and cash-out refinances
The main disadvantage of a HELOC is its variable interest rate, which can lead to fluctuating payments. Also, if you sell your home, you’ll likely need to pay off the HELOC in full.
Whether there’s a better option than a HELOC depends on your specific needs and circumstances. A home equity loan or cash-out refinance may be a better option if you need a large lump sum and prefer a fixed interest rate.
The main downside of a cash-out refinance is that it can extend your repayment period and increase your overall interest costs. Also, you’ll need to pay closing costs, which can be substantial.
Getting approved for a cash-out refinance can be challenging if you have poor credit or high debt-to-income ratios. Lenders also typically require you to have at least 20% equity in your home.
Applying for a cash-out refinance can temporarily lower your credit score because of the hard inquiry on your credit report. However, making on-time payments can help improve your credit over time.
Remember, whether you choose a HELOC or a cash-out refinance, it’s important to manage your home equity wisely. Consider your financial goals, the current market conditions and your long-term plans before making a decision.