Cash-out refinance vs. HELOC: Which is best for you?

A cash-out refinance allows you to replace your current mortgage with a larger one and keep the difference. Alternatively, a home equity line of credit is a second mortgage that allows you to borrow your equity as needed. If you need to borrow money for significant expenses such as home renovations, college expenses, or debt consolidation, knowing the difference between a cash-out refinance and a HELOC will help you choose the right solution for you.

What is a cash-out refinance?

A cash-out refinance replaces your current home loan with a larger mortgage. Once you pay off your original loan, you keep the difference to use as you like and repay it as part of your new mortgage. Unlike a second mortgage, which adds a separate loan and monthly payment, a cash-out refinance consolidates everything into a single mortgage.

Through this process, you’re borrowing your home equity by refinancing to a higher loan amount. This may increase your monthly payment, cost you more in interest, and extend your loan term.

Cash-out refinance requirements

Getting a cash-out refinance is a lot like getting a mortgage to buy a home. You'll need to apply with a lender and document your income, credit history, and your home’s value. To qualify for a cash-out refinance, borrowers typically must meet the following requirements:

• Existing home equity: Most lenders require that you maintain at least 20% equity in your home after the refinance. This means you must have enough equity in your home to borrow.
• Credit score: A minimum credit score of 620 is generally needed for conventional loans.
• Debt-to-income ratio: For conventional cash-out loans, a DTI ratio below 50% is usually required. Federal Housing Administration and Veterans Affairs loan guidelines may allow higher DTI ratios, depending on your credit or cash reserves.

How a cash-out refi works

A cash-out refinance replaces your existing mortgage with a new, larger loan. You use the proceeds of the new loan to pay off the old loan and keep the difference in cash. This lets homeowners borrow the equity they've built up in their property without taking out a second mortgage.

Here’s a simple breakdown of how it works:

1. Determine your home’s current value. Suppose your home is currently worth $400,000.
2. Check your existing mortgage balance. You still owe $250,000 on your mortgage, giving you $150,000 in equity.
3. Choose new loan amount: Most lenders let you borrow up to 80% of your home’s value, which means you can refinance with a loan for $320,000.
4. Receive the cash difference: After paying off the existing $250,000 mortgage, you receive the remaining $70,000 as cash, though you’ll have to pay closing costs as well.

This new loan replaces your original mortgage and comes with updated terms, such as a new interest rate, monthly payment, and a reset loan term. Your new monthly payment may be higher depending on the amount borrowed and the loan terms.

Cash-out refinancing is often used to borrow cash for major expenses like home improvements, consolidating debt, or education costs.

What is a HELOC?

A HELOC is a second mortgage that allows homeowners to borrow money against the equity they’ve built in their home. It works like a credit card, with your equity establishing the spending limit. You can borrow money as needed at a much lower interest rate than an unsecured credit card, and you only have to pay on interest on what you spend.

While Rocket Mortgage® doesn’t currently offer HELOCs, we’re committed to helping you understand all your home loan options so you can choose the path that’s right for you.

HELOC requirements

Requirements for a HELOC include:

• Existing home equity: As with a cash-out refinance, you need to have enough equity in your home to borrow with a HELOC.
• Credit score: The requirement for many lenders is 680, although some may require a minimum of 720. For reference, the standard credit score needed for a first mortgage is around 620, making HELOCs more challenging to qualify for.
• DTI ratio: HELOC lenders look for a 43% or lower DTI ratio.

How a HELOC works

A HELOC is a second mortgage, so you’ll need to make payments on it in addition to your primary monthly mortgage payment.

A HELOC has two phases:

• Draw period: This initial phase often lasts 5 to 10 years. This is when you can borrow from your available credit as needed. You’re usually only required to make interest-only or minimum payments.
• Repayment period: Once the draw period ends, you begin making full monthly payments that include both principal and interest until the balance is paid off. This typically takes 10 – 20 years.

This offers flexibility up front, but it’s important to plan for the higher payments that come in the repayment period.

HELOC vs. cash-out refinance: A comparison

Although both options allow you to borrow equity in your home, there are important differences to consider when choosing between them.

Cash-out refi vs. HELOC: Where they overlap

The most notable similarity is that both loan types use home equity as collateral. Both types of loans also can be used for many purposes, including home improvements or debt consolidation. They may even offer competitive interest rates compared to personal loans or credit cards. However, since your home is on the line, it's essential to borrow responsibly and have a solid repayment plan in place.

Cash-out refi vs. HELOC: Where they differ

Since a cash-out refinance replaces your primary mortgage, it comes with more attractive rates and less in-depth requirements for approval. HELOCs typically take the form of a second mortgage and are considered riskier for lenders. They have variable interest rates, which means you may pay more over the lifetime of the loan. On the other hand, the extended draw period of a HELOC may work better for borrowers looking to access their funds as needed over a longer period. They also differ in how and when borrowers receive their money and when the money needs to be repaid.

Cash-out refinance vs. HELOC: 5 things to consider

Comparing the pros and cons of a cash-out refinance versus a HELOC can help homeowners make the best choice for their financial situation. As you evaluate your options, it’s important to consider several key factors that can impact both the short- and long-term outcomes.

1. Think about loan terms

As discussed, a cash-out refinance means getting a new mortgage with new loan terms. You should make sure those terms, such as the length of your mortgage and the rate you’ll be paying, will work for you.

HELOCs, on the other hand, have their own loan terms, separate from your existing mortgage. They typically come with a draw period of 10 – 15 years and a repayment period of 10 – 20 years. The repayment period can be expensive for some homeowners, depending on interest rates and how much they paid off during the draw period.

2. Consider payment options

You should also consider how you’ll receive your funds. If you’re in need of a one-time, lump sum of money for a renovation or personal expense, a cash-out refinance will be simpler. If your prefer to access your funds over time, you’ll be better off with a HELOC.

3. Compare rates

Rates are always a key factor when comparing loan options. For homeowners who prefer fixed rates, a cash-out refinance will be more comfortable, as their payments won’t change over time. But if you’re comfortable with an adjustable rate, HELOCs may offer you access to more equity overall. Just remember, HELOC interest rates are generally a little higher.

4. Estimate closing costs

If you want to pay less up front, HELOCs may be a better option. This is because refinancing incurs closing costs, while HELOCs typically do not. Those upfront costs for a cash-out refinance can range from 3% – 6% of the loan amount, which can significantly affect your available cash and overall affordability.

5. Don’t forget taxes

There are also tax implications of refinancing versus taking out a line of credit. The IRS views refinances as a type of debt restructuring. This means there are significantly fewer deductions and credits you can claim compared to when you got your first mortgage.

The bottom line: Make your home’s equity work for you

Because borrowing against your home carries financial risk, taking out any type of home loan is a major decision. If you’re still unsure whether a cash-out refinance or a HELOC is the better fit for your situation, consider speaking with your lender. They can walk you through the pros and cons of each option and help you make an informed choice based on your goals and financial profile.

Already know that a cash-out refinance is the right path for you and your home equity? Apply for a cash-out refinance today!