Cash-Out Refinance Vs. HELOC: Which Is Best For You?

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 versus HELOCs (home equity lines of credit) to help you determine which path is best for you.

As your mortgage matures, you’ll typically gain equity in your home. Home equity is your property’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’ve 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.

Cash-Out Refinance

A cash-out refinance is a type of mortgage that allows you to take on a larger mortgage in exchange for accessing the equity in your home. Instead of a second mortgage, which means taking out a second loan with its own separate monthly payment, a cash-out transaction means paying off your existing mortgage with a new one. Through this process, you take equity out of your home by refinancing to a higher loan amount (which could increase your monthly payment). You can choose to keep the same term length.

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

Here are the requirements for approval:

• Existing home 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 have a Department of Veterans Affairs (VA) loan and 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 620 or higher.
• DTI ratio: For conventional loans, you’ll need a debt-to-income (DTI) ratio of less than 50%. For FHA and VA loans, your ratio can be higher. 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 or extending your loan term to lower your monthly payments, you may be better suited for a rate and term refinance.

Home Equity Line Of Credit

A home equity line of credit (HELOC) is a type of mortgage that allows homeowners to borrow money against the equity they’ve built in their home. A HELOC will take the form of a second mortgage unless you’ve paid off your first mortgage completely. 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 time frame. Rocket Mortgage® does not currently offer HELOCs.

When deciding between a cash-out refi and a HELOC, you may also find yourself considering the differences between a cash-out refinance and a home equity loan. 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.

How A HELOC Works

Since a HELOC will be your second mortgage unless you’ve fully paid off your first, you must remember you’re likely to be adding another loan to your property, which would mean an additional monthly mortgage payment to consider. With HELOCs, there are separate periods for borrowing and repayment, although you’ll 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’s possible to extend your draw period by refinancing your HELOC.

Here are the requirements for approval:

• Existing home 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. The requirement for many lenders is 680, although some may require a minimum of 720.
• DTI ratio: You’ll also need a lower DTI ratio, with most HELOC lenders looking for 43% or lower.

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.

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

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

Since a cash-out refinance is considered a first 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. 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 time period. These two paths also differ in how and when you will receive your money, when the money needs to be repaid and more.

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

Think About Loan Terms

As we’ve mentioned, cash-out refinances mean 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, seem favorable to 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.

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 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’ll 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 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. As we’ve noted, HELOC interest rates are generally a little higher.

Estimate Closing Costs

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

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, 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.

Still unsure whether a cash-out refinance or HELOC is right for you? Here are a few commonly asked questions to help you decide.

Can I use a cash-out refinance to pay off a home equity line of credit?

As long as you have the equity available to cover a cash-out refi, you can use a cash-out refinance to pay off a HELOC.

Is a cash-out refi or a HELOC easier to qualify for?

Typically, cash-out refinances are easier to qualify for than HELOCs. That’s because a HELOC carries a greater risk for lenders.

Can I borrow more with a HELOC or a cash-out refinance?

The amount you qualify to borrow with both a HELOC and a cash-out refinance depends on the amount of equity you have in your home. Lenders usually don’t loan borrowers more than 80% of their home’s value for cash-out refinances and no more than 85% for a HELOC.

When do I have to repay a cash-out refinance or HELOC?

Since a cash-out refinance replaces your existing mortgage loan, you’ll start to make monthly payments when the loan is disbursed. HELOCs typically feature interest-only payments during your draw period, then switch to monthly payments when you reach the monthly repayment period.

Do cash-out refis or HELOCs have lower credit score requirements?

Cash-out refinances generally have lower credit score requirements. To qualify for a cash-out refinance, most lenders look for a credit score of at least 620. To qualify for a HELOC, expect a credit score closer to 700 to qualify.

Do cash-out refinances or HELOCS have a higher interest rate?

Compared to HELOCs, cash-out refinances are less risky for lenders, meaning they are often able to provide lower interest rates – though you may need to anticipate higher upfront fees in the form of closing costs.

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.

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