Cash-out refinance vs HELOC: Which is better?

With home values near historic highs, many borrowers are evaluating options to take cash out of their homes. There are many financing options available, including a cash-out refinance or a home equity line of credit (HELOC). A cash-out refi replaces your original mortgage with a larger loan, while a HELOC is a line of credit that allows you to borrow and repay as needed. Both borrowing options can be good choices to access your home’s equity. Learn the differences between a cash-out refinance vs. HELOC to decide which one matches your needs.

What is a cash-out refinance?

When you refinance your home for more than the current mortgage balance and pull cash out, this is known as a cash-out refinance. These loans allow homeowners to lock in a low-interest rate for the duration of their home loan. Repayment is spread out over many years, which makes monthly payments more affordable for borrowers.

How does a cash-out refinance work?

Getting a cash-out refinance follows the same path as your existing mortgage. The only difference is that your new mortgage will have a larger balance due to the cash you’re pulling out.

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You’ll apply for a new mortgage based on your current balance plus the money you want to withdraw. You may also choose to include money for the closing costs to reduce your out-of-pocket expenses. Interest rates for a cash-out refinance tend to be a little higher than a purchase mortgage or a rate-and-term refinance. Depending on the interest rate, the remaining term of your existing mortgage, and the details of your new loan, your monthly payment could increase, decrease, or remain roughly the same.

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When the cash-out refinance loan closes, the lender pays off your existing mortgage. The balance left over is then wired to your bank account or issued as a cashier’s check as a lump sum. You can then use the money for whatever purpose you desire.

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It is important to note that the repayment term starts over with the new mortgage. Consider getting a mortgage with a shorter term to avoid restarting the 30-year repayment period. For example, if you've had your existing mortgage for 10 years, you may want to replace it with a 15 or 20-year mortgage to keep a similar loan payoff date.

What are the requirements for a cash-out refinance?

Eligibility for a cash-out refinance varies by lender and the type of loan you’re applying for. However, these are the basic eligibility requirements:

• Adequate home equity. You need to have enough equity in your home to cover your existing mortgage and the amount you want to withdraw. Additionally, you cannot exceed the lender’s maximum loan-to-value (LTV) ratio. The maximum LTV varies by lender and which mortgage type you select, such as 80% LTV for a conventional mortgage
• Ability to repay debt. Most lenders have a maximum debt-to-income (DTI) ratio for their loans, depending on which type of loan you're using. The Consumer Financial Protection Bureau recommends a maximum DTI of 43%. The DTI ratio compares all of your monthly minimum payments against your gross income. Payments include mortgages, auto loans, student loans, credit cards, and other debts.
• Credit score. You must have a qualifying credit score in order to get approved for a loan. The minimum credit score varies by lender and mortgage product, like a 550 FICO for FHA or VA loans and 620 for conventional loans. There are different mortgage products for every type of borrower, but you’ll generally pay a higher rate if your score is lower.

Pros and cons of a cash-out refinance

Pros

• Access to a lump sum of cash
• Potential for lower interest rates
• Spread repayment out over a longer term

Cons

• Refinancing can be expensive
• Lose out on existing low mortgage rate
• Could lose your home if you don’t make payments

When to consider a cash-out refinance

A cash-out refinance is a popular option for homeowners when interest rates are low. It allows them to take cash out of their home’s equity to consolidate debt, do home improvement projects, or pay for other large purchases and spread the payments over a long period of time.

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While these loans make sense for some borrowers, they can impact your long-term financial goals. Refinancing into a new 30-year loan could extend the repayment period into retirement. Additionally, the higher mortgage payments and additional length of the repayment term could impact your ability to save and invest for other goals.

What is a home equity line of credit (HELOC)

A home equity line of credit (HELOC) is a line of credit secured by your home’s equity. HELOCs allow you to access your home’s equity without having to refinance your existing mortgage. During the draw period, you can draw and repay your balance repeatedly up to your total available credit limit. Drawing down the money as you need it versus getting it as one lump sum means that you only pay interest on the money you’re actually using. You’ll make interest-only payments during the draw period before it converts to an amortizing loan to pay off the balance.

How does a HELOC work?

A HELOC is a line of credit based on your home’s equity. If you don’t use the line of credit, you won’t pay any interest. Interest charges are generally based on the average daily balance of the amount borrowed during each statement period. Monthly payments are interest-only, but you can pay extra to reduce your balance and interest expense.

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Borrowers have a draw period where they can borrow and repay the line of credit repeatedly. This draw period is typically five to ten years. After that, the remaining balance converts into an amortizing loan with a fixed rate based on the interest rates at the time of conversion. Generally, the repayment period is 20 years.

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Some lenders allow borrowers to convert portions of their balance into a fixed-rate loan during the draw period. This allows homeowners to lock in a fixed rate on a portion of their balance. It also creates a set monthly payment to pay off that balance over a defined period of time.

What are the requirements for a HELOC?

Lender requirements vary when getting a HELOC, but basic underwriting standards still apply.

• Loan-to-value (LTV) ratio. Lenders have a maximum LTV that they’ll lend against your home’s appraised value. Usually, they’ll go up to a combined 80% LTV, but some may go higher. Your existing mortgage is subtracted from this number to determine the maximum line of credit you’re eligible for. In this example, a home is worth $400,000 and currently has a $200,000 mortgage. At an 80% maximum LTV, the borrower is eligible for a HELOC up to $120,000.
• Ability to repay. Lenders look at your debt-to-income (DTI) ratio when evaluating your ability to repay a loan. They’ll add up all of your required minimum payments and divide that total by your gross income. Typically, your total DTI, including your new payment amount, should be under 43%.
• Solid credit score. A qualifying credit score is needed to get approved for a HELOC. Having a history of on-time payments and keeping your balances low are two steps to building a good credit score.

Pros and cons of a HELOC

Pros

• Flexibility to borrow as needed within a predetermined limit
• Interest-only payments can be easier on your monthly budget
• Potential tax advantages

Cons

• Monthly payments can spike with rate increases
• High balances can affect utilization and reduce credit score
• Easy to accumulate debt quickly on frivolous purchases

When to consider a HELOC

A HELOC is a good financing option for a variety of situations. Overall, they are best when you are unsure of how much money you need. With home equity loans or cash-out refinancing, if you need extra money, you have to do another loan. In some cases, homeowners borrow more than what they need to avoid running out of money. This results in paying more interest than you need to.

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Additionally, a HELOC provides instant liquidity for emergency funds or short-term cash needs. Their interest-only payments provide more affordable payments, and you’ll only pay interest on the money used. By comparison, you have to pay interest on the entire loan amount on a cash-out refinance or home equity loan, whether you’re using the money or not.

Comparing cash out refinance vs HELOC

Before applying for either loan type, compare the details of HELOC vs cash-out refi.

Interest rates and loan terms

Interest rates on a HELOC are variable during the draw period. Your initial monthly payment is interest-only, but you can pay extra to reduce your balance without prepayment penalties. As you pay down your balance, your purchasing power increases, similar to how a credit card works.

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Some lenders allow HELOC borrowers to lock in the interest rate on a portion of their balance by converting it to an amortizing loan. When the draw period expires, the remaining balance automatically converts to a loan with principal and interest payments.

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Most cash-out refinance loans offer a 30-year term with a fixed rate. However, borrowers may choose a shorter term to pay off the loan faster. Additionally, you may get a loan with a variable APR to have a lower payment during an introductory period.

Closing costs and fees

HELOCs offered by banks and credit unions typically do not charge application or origination fees. The bank may also waive the appraisal, closing, and other costs associated with the loan. These waivers make it cost-effective to obtain a HELOC, even if you don’t have immediate plans to use it. However, some banks recoup these costs if you don’t borrow against it or close the account within three to five years.

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A cash-out refinance has the same closing costs as a traditional mortgage. These costs may include title insurance, appraisal, county taxes, and other fees. Some lenders also charge origination fees for creating the loan. Borrowers can choose to pay points on their mortgage to pay down the interest rate.

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Borrowers often have the option of paying closing costs upfront or adding them to their mortgage balance. While adding closing costs to the mortgage reduces how much you’ll pay out-of-pocket, you’re paying interest on those fees for the duration of your mortgage.

Impact on equity and mortgage

The impact on your home’s equity with a cash-out refinance is immediately known based on how much cash you withdraw. As you make payments on the new mortgage and reduce your balance, you’ll slowly increase your home’s equity. When the loan term is complete, your home will be paid off.

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With a HELOC, it is difficult to know how it will affect your home’s equity. You are approved for a maximum credit limit, but this doesn’t affect your equity until you make draws from your line. Paying down your balance increases your equity and available credit. Some borrowers get into financial trouble by maxing out their HELOCs and using up their equity. Consider getting a smaller line of credit than what you are eligible for to protect the equity in your home.

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When your HELOC’s draw period expires, it converts into a term loan. You’ll make equal monthly payments that reduce your balance. When that term loan is complete, your home equity loan will be paid off.

Final thoughts

A cash-out refinance and HELOC are two common options for homeowners to access their home’s equity. Homeowners receive a lump sum of cash and have consistent monthly payments with a cash-out refi. HELOCs provide greater flexibility because borrowers have a maximum credit limit and only pay interest on what they borrow. They’ll make interest-only payments during the draw period before it converts into a fixed-rate loan after five to ten years. Both lending options have pros and cons, so consider your financial goals before deciding which one to pursue.