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Cash-Out Refinance Vs. Home Equity Line Of Credit (HELOC): Which Is Best For You?

Katie Ziraldo6-minute read

March 10, 2021

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There’s nothing like the excitement of buying a home. But once you’ve spent some time in it, you may notice a need for certain home improvements – or even want to remodel part of your house entirely. Whether you’re in need of funds for a home project, a life event or even to pay off other forms of debt, accessing the equity in your home may be an effective way to make your dreams come true.

But with so many refinance and loan options available, it’s tricky to know where to start. In this article, we’ll take a critical look at cash-out refinances vs. home equity lines of credit, or HELOCs, to help you determine which path is best for you!

Cash-Out Refinance Vs. HELOC: A Definition

As your mortgage matures, you gain equity in your home. Equity is your home’s value minus what you currently owe on your mortgage.

For example, let’s say you purchased your home for $300,000 and after a few years of making payments, you’ve lowered what you owe your lender to $200,000. Assuming your home is still worth $300,000, that means you have built up $100,000 worth of equity in your home.  

Cash-out refinances and HELOCs both capitalize on your home’s equity by allowing you to access and use a part of it for your next project.

Cash-Out Refinancing

A cash-out refinance is a type of mortgage refinancing that allows you to take on a larger mortgage in exchange for accessing the equity in your home. Unlike a second mortgage, a cash-out refinance doesn’t add to your monthly payment, but rather the length of the loan. Once you pay off your old mortgage, you simply begin to pay off your new one.

The process of a cash-out refinance is much like the process you went through for your initial mortgage. You choose a lender, submit an application, provide documentation and if you get approved, all there is left to do is wait for your check!

Requirements for approval:

  • Equity: You need to have equity in your home to capitalize on this type of refinance. Your lender won’t allow you to cash out all of the equity in your home unless you qualify for a VA refinance, so before pursuing this route, we recommend taking a careful look at your home’s equity to ensure you can cash out enough to accomplish your goals.
  • Credit score: To refinance, you typically need a credit score of at least 580. But if you’re looking to take cash out, the credit score requirement jumps up to 620 or higher.
  • DTI ratio: You will also need a debt-to-income (DTI) ratio of less than 50%. Your DTI ratio is your total of your monthly payments divided by your monthly income.

If you aren’t in immediate need of cash but are interested in changing the terms of your current mortgage to get a more favorable rate, you may be better suited for rate-and-term refinancing.

Home Equity Line Of Credit

A HELOC is a type of second mortgage that allows homeowners to borrow money against the equity they have built in their home. They function similarly to credit cards in that you’re able to access and utilize the funds as you choose – up to a certain limit and within a certain timeframe. Rocket Mortgage® does not offer HELOCs.

As opposed to home equity loans, which come as a one-time, lump sum of cash, HELOCs offer flexibility because you can borrow against your credit line at any time. This makes HELOCs a popular option for an emergency source of funds, as there are no interest charges for untapped funds.

So how does it work? Because it’s considered a second mortgage, you must remember you’re adding another loan to your property, which means an additional monthly mortgage payment to consider. With HELOCs, there are separate periods for borrowing and repayment, although you will make payments on the loan through both periods.

In the first period, also known as the draw period, your line of credit is open and available for use. During this time, you’re able to borrow as needed while making minimum or interest-only payments on what you owe. Once your draw period ends, you’ll no longer have access to the HELOC funds and will be required to start making full monthly payments that cover both the principal balance and interest. This is called the repayment period. The lengths of these periods depend on the type of loan you get, although it is possible to extend your draw period by refinancing your HELOC.

Requirements for approval:

  • Equity: As with a cash-out refinance, you need to have a reasonable amount of equity in your home for a HELOC to be worth your time.
  • Credit score: Although the standard credit score needed for a first mortgage is around 620, HELOCs tend to be more difficult to obtain. Because the interest rates can get hefty if you’re not careful, it is typically not recommended to pursue this path with a credit score below 700.
  • DTI ratio: You will also need a lower DTI ratio, with most HELOC lenders looking for 43% or lower.

Low rates were a big story in 2020. It was a great year to refinance!

Great news about 2021 so far: Rates are still relatively low.

Cash-Out Refinance Vs. HELOC: A Comparison

Although both options allow you to access equity in your home, there are important differences between cash-out refinances and HELOCs that you must consider when choosing the best option for you.

 

Cash-Out Refinance

Home Equity Line Of Credit (HELOC)

Length Of The Loan

Extends the mortgage loan term

Adds a second loan rather than extending the timeframe

Interest Rate

Offers fixed interest rates

Offers variable rates, so the interest rate you pay will fluctuate with the market

Monthly Payments

Offers fixed, predictable monthly payments

Requires interest-only payments during the draw period. During the repayment period, payments are required on both the principal balance of the loan and the interest

Where They Overlap

There are many commonalities between HELOCs and cash-out refinancing – most notably the importance of home equity for both options as well as what they can be used for, from refinancing for home improvements to refinancing for debt relief.

Where They Differ

But despite all of their similarities, there are also some core differences between these two forms of financing.

Because a cash-out refinance is considered a first mortgage, it comes with more attractive rates and less in-depth requirements for approval. As a second mortgage, HELOCs are considered riskier and therefore have variable interest rates, which means you may pay more over the lifetime of the loan. These two paths also differ in how and when you will receive your money, when the money needs to be repaid, and more.

How To Choose Between A Cash-Out Refi Or HELOC

Weighing the pros and cons of each option can help homeowners choose between cash-out refinances and HELOCs. When comparing the two, we recommend considering the following factors.

Think About Loan Terms

As we’ve mentioned, cash-out refinances extend the length of your mortgage loans, while HELOCs add a second loan to your current timeframe and therefore an additional monthly payment. So, if you can’t reasonably commit to the additional monthly expense, the cash-out refinance is probably a safer option.

Consider Payment Options

You should also consider how you will receive your funds. If you’re in need of a one-time, lump sum of money to be used for a renovation or personal expense, a cash-out refinance will be simpler. But if you prefer to have access to your funds over a span of time, you will be better off with a HELOC, as the draw period typically lasts around 10 years and you can use your money as needed during that time.

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 your payments will not change over time. But if you’re comfortable with an adjustable rate, HELOCs may offer you access to more equity overall.

Estimate Closing Costs

If you want to pay less upfront, HELOCs may be a better option as refinancing incurs closing costs, while HELOCs typically do not.

When calculating closing costs, you should also consider PMI, or private mortgage insurance, as it applies to refinancing. PMI protects your lender if you stop making payments on your loan, so if you make a down payment of less than 20% on your home, your lender will likely require you to pay PMI. In some cases, taking on a HELOC can help you avoid paying for PMI altogether.

Don't Forget Taxes

There are also tax implications of refinancing vs. taking out a line of credit. The IRS views refinances as a type of debt restructuring, which means the deductions and credits you can claim are significantly less plentiful than when you got your first mortgage. Because refinances are considered loans, you would not need to include the cash from your cash-out refinance as income when filing your taxes.

Depending on what your cash is used for, it may or may not be tax deductible. With both cash-out refinances and HELOCs, your cash will only be tax deductible when used for capital home improvements, such as remodels and renovations.

The Bottom Line: Make Your Equity Work For You

Due to the risks of debt, taking out any kind of loan on your home is a big decision. If you’re still unsure if a cash-out refinance or HELOC is a better financial fit for you, we recommend talking with your lender about both options so they can help you choose the plan best suited for your specific needs.

Interested in moving forward with a refinance? Apply online now!

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Katie Ziraldo

Katie Ziraldo is a writer focused on financial learning for current and future homeowners. She found her love of writing through her experience working with various newspapers, such as the Detroit Free Press. Her financial literacy stems from her four years as a Recruiter, when she learned the details of every role in the mortgage process. As a writer, she uses that knowledge to create relevant content for homeowners to help them reach their goals.