Cash-Out Refinance, HELOC and Home Equity Loans: Which Is Best for You?
If you’re in need of cash for any reason, your home may be the best place to find it. With a cash-out refinance, a home equity line of credit (HELOC) or a home equity loan, you can use your home as collateral and get the funds you need.
Each of these financial products works differently, so it’s crucial to understand the ins and outs of each type of loan before choosing one. This guide will show you how each of these products works and the potential costs, so you can figure out which loan might suit your needs best.
A cash-out refinance replaces your current mortgage with a new loan for more than you owe now. The benefit: You get to take the difference between your old loan and your new one in cash, using it as you see fit. For example, let’s say you owe $100,000 on a home that is worth $250,000. With a cash-out refinance, you might refinance up to 85 percent of your home’s value ($212,500) and take part of the difference back in cash to spend however you want.
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.
- The interest you pay may be tax deductible.
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 percent equity in your property, you may need to add PMI, or private mortgage insurance, back onto your loan.
Who can qualify for a cash-out refinance?
Since a cash-out refinance is essentially the same as taking out a new mortgage, requirements for qualifying are similar. Homeowners who own their homes and meet the following criteria may qualify:
- Good or excellent credit
- Significant home equity
- Ability to repay the loan
- A debt-to-income ratio — including the new mortgage payment — acceptable to the lender
A HELOC, or home equity line of credit, is a type of revolving loan that uses your home as collateral. Generally speaking, lenders who offer HELOCs provide a specific line of credit based on the home’s current appraised value. HELOCs work much like a credit card, in that you aren’t charged interest until you borrow money and start paying it back, and can borrow up to a certain specified sum.
While some HELOCs are set up differently, many have 20-year terms with an initial 10-year draw period during which you can borrow from your line of credit. Once the draw period is over, some loans will allow you to renew it while others will not.
Advantages of a HELOC
- Current interest rates are near historic lows. This means you could qualify for a low interest rate that makes taking out a HELOC very affordable and attractive.
- HELOCs only require you to repay the money you borrow, which means you can get lower monthly payments if you don’t borrow the maximum your HELOC allows.
- HELOCs allow you to deduct the interest on home equity debt totaling $100,000 or less on your taxes, much like a traditional mortgage.
Disadvantages of a HELOC
- Interest rates for HELOCs are typically variable, which means your monthly payments could change, and you could end up with a higher 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.
- Many HELOCs offer interest-only repayment plans, which means you’re only required to pay interest during your loan’s draw period, which is usually the first 10 years. After that, your minimum payment may increase significantly, which leaves some borrowers struggling at that point.
- 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?
To qualify for a HELOC, you typically need to meet the following criteria:
- You have a low debt-to-income ratio, generally 43 percent or below
- You need good or excellent credit, or a score of at least 670 to qualify for a good interest rate.
- You need equity in your home to borrow against.
Home equity loan
A home equity loan works like a HELOC, in the sense that you borrow against your home’s value minus your remaining mortgage. The biggest difference? A home equity loan allows you a lump sum upfront, and the monthly payments are fixed thereafter.
Like the other financial products on this list, you can use a home equity loan for a home remodeling project, debt consolidation, college costs or any other goal.
Advantages of a home equity loan
- Your interest rate and monthly payment are fixed, so you’ll always know what you need to pay each month.
- You get a lump sum payout, and you can pay it back over time.
- The interest rate on your home equity loan may be tax deductible.
Disadvantages of a home equity loan:
- You have to borrow a large sum upfront, and don’t have the ability to “borrow as you go.”
- 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?
Generally speaking, you need to meet the following criteria to qualify for a home equity loan:
- You need equity in your home, usually more than 20 percent after your home equity loan has closed. However, some lenders may let you borrow up to 90 or 95 percent of your home’s value.
- 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, including housing costs and all other debts combined.
At a glance: Cash-out refinance vs. HELOC vs. home equity loan
|How are they different?|
|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 up to 20 years.||Home equity loans can range from 5-20 years.|
|Borrowing limits||You can usually borrow up to 80 percent of your home’s value, although lender requirements vary.||The Federal Trade Commission (FTC) reports you may be able to borrow up to 85 percent of your home’s value (in total) depending on your creditworthiness.||Some lenders may let you borrow up to 90 or 95 percent of your home’s value across your first mortgage and home equity loan.|
|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 rules||You typically need at least 20 percent equity in your home after your cash-out refinance closes.||Most lenders allow you to borrow up to 85 percent of your home’s value including both your first mortgage and a HELOC.||You may be able to borrow up to 95 percent of your home’s value across a first mortgage and home equity loan, although lender requirements vary.|
|Interest Rates||Fixed or variable (See current mortgage rates in your area)||Variable (See current HELOC rates in your area)||Fixed (See current home equity loan 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 2-4 percent 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 – 5 percent of the loan.||Closing costs typically cost 2- 5 percent 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.|
Comparing total costs
Before you can decide on a cash-out refinance, a home equity loan or a HELOC, it’s important to compare total costs. Assume a borrower, Mary, owns a property worth $300,000. She has a FICO score of 780 and owes $150,000 on her home.
If Mary decided to use her home as collateral with each of these loan options and she 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 percent||20 years||$289.98||$69,987.07 (includes $50,000 cash-out and 2 percent closing costs bundled into loan)|
|HELOC||4 percent*||20 years||$170 (if interest-only years 1-10), $516.35 (years 11-20)||$73,171.99* (includes $50,000 loan and 2 percent closing costs bundled into loan)|
|Home Equity Loan||4 percent||20 years||$309.05||$73,171.99 (includes $50,000 loan and 2 percent closing costs bundled into loan)|
*Could rise or fall, because HELOCs have variable interest rates
Which choice is right for you?
While the hypothetical situation described above can give you a good idea of how each of these loan options works, it’s important to look closely at your own situation before you decide which option is best for you.
Here are some factors to consider as you decide:
- The new interest rate: “The biggest factor to consider is the interest rate — variable or fixed,” notes Jonathan Patrick, a former mortgage lending officer from the banking industry. “Most home equity loans are fixed, but most HELOCs are variable. That is the biggest distinction to consider.”
- How much you want to borrow: If you want the ability to borrow up to 90 or 95 percent of your home’s value, you may be better off with a home equity loan instead of a cash-out refinance. That’s because home equity loans typically let you borrow more of your home’s value, whereas cash-out only lets you borrow up to 80 percent.
- 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 instead of recasting your mortgage entirely with a cash-out refinance. If you can qualify for a lower interest rate, however, doing a cash-out refinance could save you money over the life of your loan.
- Closing costs: “Closing costs for a cash-out refinance can be very costly,” Patrick says. These costs may not be worth it if you’re not getting a lower interest rate on your new mortgage than the one already in place. If you want to avoid too much in closing costs, look for a lower-cost HELOC or home equity loan.
- Additional costs: If you refinance your home mortgage with a cash-out refinance and wind up owing more than 80 percent of your home’s value, you could have to pay PMI (private mortgage insurance), notes Patrick. On the flip side, taking out a HELOC or home equity loan won’t result in PMI.
- Payment terms: If you want a fixed payment on your loan, you will likely want to go with a cash-out refinance with a fixed rate or a home equity loan, notes Patrick. “HELOCs almost always come with a variable rate, which means your payment will likely fluctuate.”
- Monthly payment: If you’re looking for a lower monthly payment the first few years, an interest-only HELOC option could give you the lowest payments upfront.
Only you can decide which type of home loan works best for you. But by comparing costs, asking yourself what your goals are, and writing out a list of pros and cons for each option based on your unique situation, you can make sure your decision is an informed one.