Pros and cons of HELOCs vs. refinancing

As a homeowner, you have many options when it comes to leveraging your home equity if you need to borrow money. Home equity lines of credit (HELOCs) and cash-out refinances are two of the most popular options because they offer a lot of flexibility, but in different ways. 

If you're curious about weighing the pros and cons of a HELOC vs. a refinance loan, we’ve got you covered. We’ll walk you through how they work and where each might make more sense for certain borrowers so you can make an informed decision. 

How a HELOC works

HELOCs are designed as a more flexible way of borrowing money. It does this by being split into two phases: a draw period and a repayment period. 

Lenders allow you to borrow money during the draw period, up to your approved credit limit. You can repay it to refresh your credit limit and borrow more again, or you can make the required interest-only payments during the draw period and hold onto that debt for later. Most draw periods last 5 to 10 years. 

When the draw period ends, you’ll enter the HELOC repayment period. You won’t be able to borrow anymore, and you’ll repay the full balance of your debt over the remaining course of the HELOC, which typically lasts for 20 years. 

Another notable feature of HELOCs is that most lenders charge variable interest rates. When the market goes up and down, so too will your monthly payments. 

How cash-out refinancing works

A cash-out refinance replaces your original mortgage with a brand-new one. Your new mortgage might have a different loan term length, interest rate, and monthly payment. It’s not too different from a regular mortgage refinance in that respect. 

Where it differs, however, is your mortgage balance. When you do a cash-out refinance, you take out a larger balance than you currently owe on your primary mortgage. The difference is paid to you in cash, as a lump sum. There aren’t any draw phases or additional fund disbursements to keep track of, like with a HELOC — it’s more of a one-and-done deal. 

Pros and cons of HELOC vs refinance

In general, if you need a flexible funding solution, a HELOC is likely your better option — but it does come with some drawbacks you should know about. Similarly, a cash-out refi may be a better fit if you’re looking to fund a one-time expense and pay it back in a predictable manner — but that’s not without its costs, either. 

Here’s what to consider when evaluating these two options:

HELOC

Pros

• Borrow as you need funds: The biggest advantage of a HELOC, for most people, is being able to borrow more money when you need it during the draw phase without having to apply for another loan. 
• Interest-only payments to start: HELOCs also add flexibility by allowing you to choose your payment during the initial draw phase. You can make smaller interest-only payments or pay off as much of your outstanding balance as you wish.
• Leaves your current mortgage intact: If you don’t want to reset your entire mortgage, a HELOC lets you finance just the things you need separately from your home loan. 

Cons

• Harder to qualify for: Since HELOCs take second place behind your first mortgage, many lenders set a slightly higher bar to qualify for a HELOC than with a cash-out refinance. You may need a higher credit score, for example.
• Variable interest rates: Your financing costs may change over time, and that can raise or lower your monthly payment, too. That can be especially hard if you’re living on a fixed income. HELOCs tend to come with higher interest rates, too.
• More complicated to manage: The variable interest rates make it harder to budget when the rates could change at any time — but so, too, does the switch from the draw to the repayment phase. If you’ve gotten used to making interest-only payments, the sudden jump in the minimum payment can be quite a shock. 
• Minimum draw requirements and fees: Some lenders require you to withdraw funds and pay annual fees, whether you’re actually using your HELOC or not. 

Refinance

Pros

• Lower interest rates: Lenders typically charge a smaller rate for a cash-out refi than for a HELOC (it’s worth noting, though, that cash-out refinance rates are still generally higher than a simpler rate-and-term refi, since you’re borrowing more money). 
• Lower potential mortgage payments: If you weren’t in a favorable market or your credit wasn’t as good when you first took out your mortgage, a cash-out refi gives you a do-over to get a lower rate. That, plus choosing a longer term length, may help lower your monthly payment even as you borrow more money.
• Easier-to-manage mortgage payments: Fitting your monthly payments into your budget is easier because you’ll only have one home debt to manage, not two. Plus, most lenders charge fixed interest rates, so your monthly payment amount won’t change. 

Cons

• Requires more equity: Most lenders require you to have 20% equity in your home, at a minimum, which is more than what’s typically required by many HELOC lenders. 
• Higher long-term interest costs: Although rates are generally lower with a cash-out refi, it’s possible to end up paying more interest by the time the debt is paid off. HELOCs are structured to encourage you to pay off some or all of the debt in the draw period, whereas it’s easier to carry that debt for up to 30 years with a cash-out refi. 
• Can’t borrow again if you need more funds: Cash-out refis offer a lump sum, vs. access to a line of credit like with a HELOC or credit card. They’re better for one-time uses, like consolidating debt or paying a contractor for a home project. 

Alternatives to a HELOC or cash-out refinance

When it comes to home equity financing, you have more options available than simply choosing between a HELOC vs. a cash-out refinance. Here are three other avenues to explore if you’re interested in leveraging your home equity:

• Home equity loan: Home equity loans sit at the junction between a HELOC vs. a cash-out refinance. They offer lump sum funding at fixed interest rates, like cash-out refis. However, they’re a secondary loan, like a HELOC, that lets you leave your primary mortgage in place. 
• Reverse mortgage: Homeowners over age 62 have the option of using a reverse mortgage, which requires no monthly payments and is repaid when you no longer need your home. They can be structured as a lump sum disbursement, a monthly payment to you, or as a line of credit. 
• Home equity investment (HEI): Home equity investments also require no monthly payments and are available as a lump sum of cash. However, unlike a reverse mortgage, you maintain ownership of the home and are not required to pay off your first mortgage. You’ll repay the money you borrowed in 30 years, along with a share of your home’s increase in value (i.e., appreciation). 

Using home equity financing, in general, has a lot of benefits when you need funding. In addition to lower rates (compared to unsecured funding options, at least), you may qualify for a tax deduction if you use those funds to upgrade your home. However, there are downsides, too, such as the closing costs to receive the funding and the foreclosure potential if you default.

Frequently asked questions

Is it better to take a HELOC or refinance?

HELOCs may be a better choice if you want the option to borrow again in the future, and if you’re able to handle fluctuating monthly payments. A cash-out refi might be better if you want payment stability, and you only need to borrow money once for something like home improvements.

Is a HELOC cheaper than a refinance?

HELOCs generally come with higher interest rates than a cash-out refinance. It’s possible to pay more interest over time with a cash-out refinance, though, since most borrowers take longer to pay off debt from a cash-out refinance than from a HELOC. It's also worth noting that a refinance has higher closing costs than a HELOC.

Is a HELOC or refinance better for borrowers with bad credit?

It’ll be harder to do either if you have bad credit. That said, lenders usually require a slightly higher credit score if you’re applying for a refinance loan than for a HELOC. 

Final thoughts

HELOCs are very popular because they allow you to match your funding to your needs more easily, but at the expense of ever-shifting payments that can be tricky to predict. On the other hand, if you didn’t get good terms on a mortgage the first time around, a cash-out refi allows you to accomplish two objectives at once: get a better mortgage and a lump sum of funds. Ultimately, what’s best for you will depend on your needs and financial situation.

Ready to tap into your home equity with no monthly payments? Explore Point’s Home Equity Investment.

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