Cash-Out Refinance, HELOC and Home Equity Loans: Which Is Best for You?
As home prices have risen since the housing crisis and Great Recession, some Americans are finding themselves with a good amount of equity in their homes. They may want to tap into that equity to fund a variety of short- and long-term goals, such as a home renovation, paying down debt or covering college tuition.
If you have decided you want to access your home equity, you can consider a cash-out refinance, home equity line of credit (HELOC) or home equity loan. This guide provides details on each product, so you can choose the best option for you.
What is a cash-out refinance?
A cash-out refinance provides homeowners with an entirely new mortgage by paying off their existing loan and replacing it with a new loan for a larger amount. With the new mortgage, homeowners receive the desired amount of cash to use as they need, and the total withdrawn is added to the remainder of the initial mortgage.
In addition to tapping into equity, a cash-out refinance can help homeowners improve on the terms of an existing loan. A new mortgage might offer a lower interest rate and shorter payment terms or provide homeowners with a fixed-rate mortgage versus an adjustable-rate loan.
Because a cash-out refinance leads to the creation of a new loan, it includes all the origination and closing costs that accompany a typical mortgage. Homeowners also pay interest for the life of the loan, as they would with their original mortgage.
Advantages of a cash-out refinance
- You can access your home’s equity for home improvements, debt consolidation or other financial goals.
- Interest rates for first mortgages are typically lower than for HELOCs or home equity loans.
- Your loan proceeds arrive in a lump sum, which you can spend however you wish.
Disadvantages of a cash-out refinance
- Because a cash-out refinance requires you to take out a new first mortgage, closing costs are typically greater than with a home equity loan or HELOC.
- Recasting your home mortgage may cause you to owe money on your home for years longer than you had planned.
- If you refinance your mortgage and wind up with less than 20% equity in your property, you may need to add private mortgage insurance.
- If you plan to take advantage of itemized deductions when you do your taxes, you might have to split your mortgage interest into two categories â€” deductible and non-deductible. This is a change under the Tax Cuts and Jobs Act of 2017, which takes effect for the 2018 tax year. There initially was some confusion about what’s deductible and what isn’t, and because a cash-out refinance generates a new first mortgage while providing cash equity, multiple rules apply. But the IRS has since clarified the conditions. â€œThe interest on the extra cash is not deductible under the new rules unless the proceeds are used to buy, build or substantially improve your home, â€ said Cindy Hockenberry, director of tax research and government relations for the National Association of Tax Professionals. Hockenberry added that you can, however, deduct mortgage interest on the original debt that was rolled into the new loan.
Since a cash-out refinance is essentially the same as taking out a new mortgage, requirements for qualifying are similar. Homeowners who meet the following criteria may qualify:
- Good or excellent credit
- Significant home equity
- Ability to repay the loan
- A debt-to-income ratio â€” including the new mortgage payment â€” acceptable to the lender
What is a home equity line of credit?
A Home Equity Line of Credit, or HELOC, is a revolving loan that uses your home as collateral. Similar to a credit card, a HELOC gives you access to a line of credit based on the desired amount of equity you wish to take from your home. Although a HELOC is originated for a specified amount, homeowners don’t have to withdraw the full line of credit. Interest only accrues on the amount withdrawn.
Most HELOCs have 20-year terms with an initial 10-year draw period, in which owners can borrow from their line of credit. Some HELOCs can be renewed after the draw period ends.
Advantages of a HELOC
- If interest rates remain low, HELOCs offer an affordable way to access equity without significant repayment costs.
- You only have to pay back the money you borrow. For example, if you secure a $15,000 loan but withdraw just $7,000, you only pay interest on the $7,000. This way, monthly payments can remain low while homeowners can still access the rest of the credit line if needed.
- On an interest-only repayment plan HELOC, monthly payments are lower during the draw period.
- Under the new tax code, you can deduct interest on a HELOC if the funds are used to â€œbuy, build or substantially improveâ€ your home.
Disadvantages of a HELOC
- Interest rates for HELOCs are typically variable, and you could end up with a higher monthly loan payment if rates surge.
- You may need to pay ongoing fees beyond the initial closing costs of the loan, including an annual membership fee, maintenance fees or transaction fees. There could also be costs related to early termination or inactivity.
- Many HELOCs offer interest-only repayment plans during the initial draw period. While that can help homeowners who need lower payment options initially, others could struggle with the steep climb in monthly payments when principal and interest are calculated.
- Whenever you use your home as collateral, you take the chance of losing it if you stop making payments.
Who can qualify for a HELOC?
- Homeowners with a low debt-to-income ratio, generally 43% or below
- Homeowners with good or excellent credit (a score of at least 670 to qualify for a good interest rate)
- Homeowners with equity in their home
What is a home equity loan?
A home equity loan is similar to a HELOC in that it lets you borrow against the home’s value minus your remaining mortgage. Unlike a HELOC, you receive a lump sum upfront, and monthly repayments are fixed for the life of the loan.
Like a cash-out refinance or HELOC, you can use a home equity loan to launch a home remodeling project, consolidate high-interest debts, pay for college costs or fund any other short- or long-term goal.
Advantages of a home equity loan:
- Home equity loans offer fixed interest rates and fixed monthly payments, so you don’t have to worry about being caught off guard by rising monthly payments.
- You receive your money in a lump-sum payout, which can be paid back over time.
- Under the new tax code, you can deduct interest on a home equity loan if you use the funds to â€œbuy, build or substantially improveâ€ your home.
Disadvantages of a home equity loan:
- Home equity loans require you to borrow a large sum upfront and pay interest on the full total; you can’t withdraw funds as needed.
- When you use your home as collateral, you place it at risk.
- Closing costs for a home equity loan may be higher than those for a HELOC.
Who can qualify for a home equity loan?
- If you have equity in your home, usually more than 20% after your home equity loan has closed, you may qualify.
- You need good or decent credit, although home equity loan options with higher rates may be available to borrowers with poor credit.
- You must be employed or have the ability to repay your loan.
- You need a low total debt-to-income ratio, which includes housing costs and all other debts combined.
At a glance: Cash-out refinance vs. HELOC vs. home equity loan
|Cash-out refinance||HELOC||Home equity loan|
|Loan term||You can refinance your home in any loan term up to 30 years.||Loan terms for HELOCs can vary. However, many last for 20 years or more.||Home equity loans can range from five to 20 years.|
|Borrowing limits||You can usually borrow up to 80% of your home’s value, although lender requirements vary.||The Federal Trade Commission (FTC) reports you may be able to borrow up to 85% of your home’s value (in total), depending on your creditworthiness.||You can usually borrow up to 80% of your hom’es value, although lender requirements vary.|
|How long it takes to get the money||You may receive a lump sum of money once your new home loan closes. The loan process can take a few weeks to a few months.||You get access to a line of credit once your HELOC closes with the bank. Withdraw cash as needed. The loan process can take a few weeks to a few months.||You usually get a lump-sum payout when your home equity loan closes, although not all home equity loans fund right away. The loan process can take a few weeks to a few months.|
|Credit score||You typically need a good FICO score (670+) to qualify, although you may qualify for an FHA cash-out refinance if you have a lower credit score.||You typically need a good credit score (670+) to qualify for a HELOC with the best rates and terms. You may qualify for a HELOC with a FICO score of 620 or more, however. Lender requirements vary.||You typically need a good credit score (670+) to qualify for a home equity loan with the best rates and terms. However, lender requirements vary.|
|Equity requirements||You typically need at least 20% equity in your home after your cash-out refinance closes.||Most lenders allow you to borrow up to 85% of your home’s value, including both your first mortgage and a HELOC.||You typically need at least 20% equity in your home after your cash-out refinance closes.|
|Interest rates||Fixed or variable (See current mortgage rates in your area.)||Variable (See current mortgage rates in your area.)||Fixed (See current mortgage rates in your area.)|
|Closing costs||Closing costs are typically hefty for a cash-out refinance since you’re getting an entirely new mortgage. Costs can include, but aren’t limited to, appraisal fee, attorney and title company fees, credit report fee, discount points, inspection fee, loan origination fee, title insurance fee, title search fee and recording fees. These costs can add up to 2% to 4% of the home’s purchase price.||HELOC closing costs can include an application fee, title search, appraisal, attorneys’ fees and points. They are typically 2% to 5% of the loan.||Closing costs also typically make up 2% to 5% of the cost of the loan.|
|Risk level||Risk is low, provided you can afford to repay your new home loan. Keep in mind, however, that since your home is still used as collateral, you can lose your home if you stop making payments.||Risk is fairly low if you can afford to make monthly payments. However, you put your home at risk any time you use it as collateral.||Risk is fairly low, provided you can make monthly payments. However, you put your home at risk any time you use it as collateral.|
Analyzing total costs
Let’s compare the total costs of all three options. A hypothetical borrower, Jennifer, owns a property worth $300,000. She has a 780 FICO score and owes $150,000 on her home.
If Jennifer decides to use her home as collateral with each of these loan options and borrowed $50,000, here’s what her costs might look like:
|Loan Type||Interest Rate||Term||Monthly Payment||Total Cost to Borrow|
|Cash-out Refinance||3.5%||20 years||$289.98||$69,987.07 (includes $50,000 cash-out and 2% closing costs bundled into loan)|
|HELOC||4%*||20 years||$170 (if interest-only years 1-10)
$516.35 (years 11-20)
|$73,171.99* (includes $50,000 loan and 2% closing costs bundled into loan)|
|Home Equity Loan||4%||20 years||$309.05||$73,171.99 (includes $50,000 loan and 2% closing costs bundled into loan)|
*Rate could change, as HELOC interest rates are variable.
How to choose between a cash-out refinance, HELOC and home equity loan
Your individual situation can help determine which option works best for you. Here are a few factors to consider.
- Fixed versus variable interest rates: If you’re looking at a HELOC or home equity loan, do you want a fixed rate or a variable rate? â€œA HELOC usually has a rate tied to the prime rate, but the rate can change depending on the terms of the loan,â€ said Jacki Channer, a Maryland-based residential lender. â€œEach HELOC has different guidelines or rules; a home equity loan can offer fixed-rate options.â€
- The interest rate on your current mortgage: If the interest rate on your current first mortgage is especially low, you might want to borrow with a HELOC or home equity loan. If you can qualify for a lower interest rate on a first mortgage, a cash-out refinance could result in lower payments in the long term.
- Closing costs: With a cash-out refinance, you can pay thousands in closing costs as you would with any first mortgage loan. For this option to be the best choice, the new mortgage should have a lower interest rate and more favorable terms than the existing mortgage, saving you money in the long term. A HELOC or home equity loan will typically have lower closing costs.
- Additional costs: If you refinance your home mortgage with a cash-out refinance and owe more than 80% of your home’s value, you may have to pay PMI (private mortgage insurance). That’s not a concern with a HELOC or home equity loan.
- Payment terms: Cash-out refinances and home equity loans offer fixed payments that won’t change during the life of the loan. HELOCs almost always have a variable rate, leading to fluctuating payments.
- Monthly payment amount: An interest-only HELOC can give you low monthly payments during the loan’s early years. This can be a good option if you expect to have a better financial situation down the road when monthly payments spike to include principal and interest. But it can be a concern if you find yourself unable to afford higher payments later.
Homeowners have three different options to access the equity in their home. While all three have advantages and disadvantages, the best choice depends on your short- and long-term goals and your individual financial situation. You can talk with a financial adviser to learn more about your options. To start, you can check out LendingTree’s home equity loan calculator.