Cash-out refinance vs. HELOC: Which one should you choose?

When you need money to cover a home remodel, pay off other debts, or another purpose, a cash-out refinance and a home equity line of credit (HELOC) are both ways to turn home equity into cash.

While both allow you to tap your home’s equity, they work very differently. Those differences can help you determine which one is best for your particular situation.

• Comparing cash-out refinance vs. HELOC
• What to know about a cash-out refinance
• What to know about a home equity line of credit
• When a cash-out refinance may make sense
• When a HELOC may make sense

Comparing cash-out refinance vs. HELOC

As you pay down your mortgage balance and the market value of your home rises, you gain equity in your home. A cash-out refinance and a home equity line of credit (HELOC) allow you to borrow against some of that equity.

Let’s look at how these two products are similar and how they differ.

How cash-out refinance and HELOC are similar

These two home equity products are similar in many ways, including:

• Equity requirements — To borrow from your home’s equity with either a HELOC or a cash-out refi, you need to have equity in your home. While the amount required differs from lender to lender, you typically need to have at least 20% equity after closing on the loan or line of credit.
• How you can use them — One of the benefits of HELOCs and cash-out refinancing is their flexibility. You can generally use the funds for any purpose, including making home improvements, covering college expenses, and refinancing other high-interest debts.

How cash-out refinance and HELOC are different

Despite their commonalities, cash-out refis and HELOCs also have a few core differences:

• Priority — When you refinance your mortgage with a cash-out refi, you replace your existing mortgage with a new, larger mortgage and get the difference in cash. A HELOC is a financial product that you take out in addition to your existing mortgage.
• Interest rates — A cash-out refinance is a first mortgage, so it usually comes with lower interest rates compared to HELOCs, which are a type of second mortgage. Second mortgages are generally riskier for the lender because if you default on your mortgage and the lender forecloses on your home, the second mortgage lender only gets paid after the first mortgage lender takes its cut.

Where to get a cash-out refinance

If you’re interested in getting a cash-out refinance, you have a lot of options, including:

• Online lenders
• Local, regional, and national banks
• Credit unions

For that reason, it’s crucial to shop around. Different lenders have different loan products, terms, rates, and fees. So shopping around and comparing offers ensures you get the best deal available.

Where to get a HELOC

HELOCs can come from online lenders, banks, and credit unions. But not all online lenders offer HELOCs — a quick search of the lender’s website should help you uncover whether yours does.

Like cash-out refinances, it’s essential to shop around before taking out a home equity line of credit to ensure you get the best rate and terms.

What to know about a cash-out refinance

With a cash-out refinance, you take out a new loan with a larger balance than your existing first mortgage. The result is a new mortgage with a higher principal balance and potentially a different rate and term.

After you close on a cash-out refinance, your new lender uses the funds from your new loan to pay off your current mortgage. You get the remaining funds in a lump sum, and the money is yours to use as you wish.

You’ll also have a new amortization schedule, which details the monthly payments you need to make to pay off your new loan by the end of its term.

This differs from a traditional rate-and-term refinance, in which you refinance your mortgage with a new lender to get a different interest rate and possibly shorten or lengthen the period for paying off the loan. With a traditional rate-and-term refi, you don’t substantially change the principal balance, although your new loan may be slightly higher if you choose to finance closing costs into the new loan amount.

How to apply for a cash-out refinance

The process for applying for a cash-out refinance is similar to the process you followed when buying your home. While the exact process may vary from lender to lender, you’ll usually take the following steps:

1. Check rates and requirements from a few lenders to see how much you can borrow, and get an estimate of the rate and fees you’ll have to pay.
2. Choose a lender, complete an application, and authorize the lender to check your credit.
3. Provide supporting documents, such as W-2s, pay stubs, bank statements, and prior year tax returns.
4. Have your home appraised to verify the home’s value.
5. The loan underwriter reviews your paperwork and credit report to make a loan decision.
6. If your application is approved, you’ll sign the closing documents and receive cash at closing.

WHAT IS A LIMITED CASH-OUT REFINANCE AND HOW DOES IT WORK?

Pros and cons of a cash-out refinance

Let’s take a deeper look at the advantages and disadvantages of a cash-out refinance so you can decide whether it’s the right choice for you.

Cash-out refinance pros

• Lower interest rates — Because a cash-out refi is a first mortgage, it generally offers lower rates than alternatives like a home equity loan, HELOC, or personal loan.
• Potential tax deductions — In general, home mortgage debt used to buy, build, or substantially improve your home is tax-deductible. So if you use the loan funds to remodel a room, replace your roof, build an addition, or make other home improvements, you may qualify for a tax break. (Be sure to discuss the potential tax benefits with your accountant or CPA.)

Cash-out refinance cons

• Puts your home at risk — Your home secures a cash-out refi. So if you face financial troubles and default on the loan, you risk losing your house.
• Closing costs — You’ll pay closing costs on a cash-out refinance, just as you would for other types of refinancing. Closing costs average 3% to 6% of the loan balance, so be sure the potential benefits are worth the cost.

What to know about a home equity line of credit

A home equity line of credit is a line of credit secured by your home. It’s a revolving line of credit that you can borrow against, repay, and borrow against again throughout the draw period, which is usually 10 years.

HELOCs are different from home equity loans because HELOCs are revolving credit, while a home equity loan gives you a lump sum that you repay in fixed installments.

For a HELOC, you’re typically only required to make interest payments during the draw period, although you can make payments toward the principal during that time. When you pay down the principal, those funds replenish your available credit.

Once the draw period ends, your HELOC transitions into a repayment period, which usually lasts 20 years. You aren’t allowed to draw from the line during the repayment period, and you must make monthly principal and interest payments until you pay the balance in full.

How to apply for a HELOC

Applying for a HELOC is similar to applying for a refinance:

1. Check rates and requirements from a few lenders.
2. Select a lender, complete an application, and authorize a credit check.
3. Provide documentation to prove your income, assets, and debts, and have an appraisal done.
4. If the loan underwriter approves your application, they’ll schedule a closing for you to sign paperwork.

The difference between closing a HELOC and a cash-out refi is that you don’t get a lump sum after closing a HELOC. Instead, you get access to a line of credit that you can draw down as needed, up to your credit limit.

Pros and cons of a HELOC

Let’s look at the advantages and disadvantages of a HELOC so you can decide whether it’s the right choice for you.

HELOC pros

• Only pay for the credit you use — Tapping only the credit you need and repaying the principal during the draw period can help you lower your overall interest costs.
• Flexible usage — There are no rules about how you can use the funds you draw from your HELOC. But if you use the funds for home improvements, you may get a tax break.

HELOC cons

• Variable interest rates — Most HELOCs have variable interest rates, so if interest rates rise during your draw or repayment period, your payments could become unaffordable.
• Minimum draws — Some HELOC lenders have minimum initial draws and minimum subsequent draw amounts. This can increase the cost of borrowing if the minimum draw amount is more than you need at that time.

HELOCS ARE POPULAR WITH HOMEOWNERS — BUT THEY COME WITH A HUGE RISK

When a cash-out refinance may make sense

If you’re still having trouble deciding between a cash-out refi or a HELOC, here’s when cash-out refinancing might make sense:

• Interest rates are low. Cash-out refis are generally fixed-rate loans, so if you can qualify for a low rate, it makes sense to lock that rate in for the rest of your loan term.
• You plan on staying in your home. The closing costs associated with a cash-out refinance can be substantial, so they’re usually not a good idea unless you plan on staying in your home long enough to make paying those closing costs worth it.
• You want to cover a large home project that’ll increase the value of your home. Cash-out refinancing is one of the cheapest ways to tap your home’s equity to cover large expenses. And if you use the funds to increase the value of your home, then you can rebuild your equity quickly.

When a HELOC may make sense

Here’s when a HELOC might make more sense than a cash-out refinance:

• You prefer to borrow over time instead of a lump sum. A HELOC is a line of credit that’s available as you need it, so it might be a better fit than a lump-sum cash-out refi in some situations.
• You plan on selling your home in the next few years. The fees associated with a HELOC are usually lower than the closing costs for a cash-out refi. This makes them a good option when you want to tap your home’s equity to pay for home improvements that’ll increase the value of your home before you sell it.
• You want to refinance other high-interest debts. HELOCs generally offer lower rates than credit cards, student loans, and other types of unsecured debts. So you can potentially lower the cost of borrowing and get out of debt faster by consolidating other debts with a HELOC.