Cash-Out Refinance vs. HELOC or Home Equity Loan

A cash-out refinance (colloquially called a cash-out refi), HELOC, and home equity loan are all ways to access your home equity without selling. They allow you to borrow against your home for a low interest rate. Many homeowners use the funds to renovate their homes, consolidate high-interest debt, or even to purchase a second home.

However, each option has positive and negative aspects. This article begins with an overview of each type of loan. Next, it compares the finer details of each loan before explaining how to get one. This article aims to help you find the best option and prepare a roadmap to receive funding.

Cash-Out Refi Explained

A cash-out refinance replaces your original mortgage with a larger one. The larger mortgage is used to pay off the smaller one and leave additional cash for the homeowner. A refinance is best done at the end of your mortgage term. You may have to pay significant penalties if you break your mortgage early. While a refi may leave you with higher interest rates than your previous mortgage, it will still be lower than a HELOC or home equity loan. However, there are more significant upfront closing costs.

To spread out costs, most homeowners will increase their mortgage amortization. A refi allows you to extend your mortgage to 30 years. This will decrease your monthly mortgage payment. Overall, a cash-out refi is best for those who want the lowest interest rate, don't mind higher upfront costs, and may wish to make significant changes to their mortgage.

HELOC Explained

A HELOC is a secured line of credit. It allows you to constantly borrow from your home equity and repay it, similar to a credit card. There is a maximum borrowing amount that you can repay and borrow from as necessary. A HELOC is the most flexible loan discussed in this article.

You won't need to pay interest on any unused funds. For this reason, homeowners open a HELOC as a precautionary emergency fund. If you never draw from the HELOC, you'll never pay interest. However, if used often, a HELOC can become expensive as the interest rate is usually variable. This means your interest rate and payment will change with the prime rate. For example, if the prime rate increases after you withdraw from the HELOC, so will your interest rate and payment.

Since you are asking your mortgage lender for a HELOC, a HELOC has lower closing costs than a cash-out refinance or home equity loan. The application process is similar to opening a credit card and usually only requires an appraisal. This is because your home is already registered as being under your lenders mortgage. The appraisal would show that there is extra equity in the home to borrow against. A HELOC is the best option if you prioritize flexibility and don't mind a slightly higher variable interest rate.

Home Equity Loan Explained

A home equity loan is a second mortgage against your home. As such, it won't affect your primary mortgage rate or payment. It can be seen as blending the interest rate and payment of the two mortgages. They are a great option if you've previously locked in a low interest rate for your primary mortgage.

You receive the loan amount upfront and must repay it with fixed monthly payments. You aren't able to periodically withdraw as a HELOC. However, unlike a refi you won't need to wait for your mortgage term to end to save mortgage-breaking fees.

Home equity loans typically have higher interest rates than HELOCs, however, you are paying for the predictability of a fixed rate. Home equity loans are an excellent option for those who prefer an up-front payment with predictable interest rates. They are also beneficial for those who can't wait for their mortgage term to end or prefer avoiding changes to their primary mortgage.

HELOC vs. Cash-Out Refi vs. Home Equity Loan

While the three options allow you to leverage home equity for a low interest rate, each has slight similarities and differences. This section will further dive into comparing a HELOC, cash-out refi, and home equity loan to empower your understanding.

*The requirement of home appraisals for home equity loans varies with each lender.

Additional Considerations

While the preceding section provides a high-level overview, this section will discuss detailed comparisons based on specific criteria. Different homeowners have different priorities, and this section will help you find your preferences and compare them across lending products.

Loan Term Length

Your term length is the amount of time you have to repay the loan. The longer the term, the lower your monthly payments, but the more interest you will pay in the long run. All options discussed have a range of term lengths from five to 40 years. HELOCs have the longest potential term length because there are two phases.

The first HELOC period is a draw phase where you can make interest-only payments on withdrawals for five to 10 years. Afterward, you must pay principal plus interest, which can amortize over 10 to 30 years. This gives you the most time to repay the loan and the potential for the highest interest payments.

A cash-out refinance has a loan term length of 15 to 30 years. The minimum loan term is typically five years, but some lenders offer shorter times. A shorter term will have higher monthly payments, but you will pay less interest in the long run.

A home equity loan has a loan term of five to 30 years. The minimum and maximum terms vary by lender, with some lenders offering terms as short as one year and others offering terms up to 30 years. Home equity loans have the shortest minimum repayment terms and the potential for the highest monthly payments.

Maximum Loan Amount

The maximum loan amount is based on the value of your home and how much equity you have. The maximum amount is calculated using loan-to-value (LTV). This metric calculates the percentage of your home equity used to secure your loan. For example, if you had an $800,000 mortgage on a $1,000,000 home, your LTV would be 80%. The loan amount is based on the appraised value of your home minus any outstanding mortgage balances.

• A HELOC usually has a maximum combined loan-to-value (CLTV) ratio of up to 85%.
• A home equity loan typically has a CLTV ratio of up to 85%.
• A cash-out refinance generally has an LTV ratio of up to 80%.

Although these are the standard ratios, some lenders may be willing to lend at a higher LTV. However, these loans tend to have higher interest rates due to increased lender risk.

Fixed vs. Variable Rate

A variable interest rate will change with the prime rate. The prime rate is the lending rate banks charge their most creditworthy customers. When the prime rate goes up, so does your interest rate and monthly payments. When the prime rate goes down, your interest rate and monthly payments also go down. A fixed rate will not change with the prime rate.

In most cases, a HELOC has a variable interest rate. However, cash-out refinances and home equity loans typically have a fixed interest rate. This means your monthly payments will stay the same for the loan life regardless of changes in the prime rate.

Withdrawal Schedule

The withdrawal schedule is the schedule of how and when you can access loan funds.

• A HELOC has the most flexible withdrawal schedule. You can withdraw funds up to your credit limit as often as you wish. There is no set schedule for withdrawals.
• A cash-out refinance, and home equity loan give you a lump sum of cash when you close the loan. You cannot access additional funds after completing.

Closing Costs

Closing costs are the additional upfront costs you must pay to your lender to receive the loan. This generally include administrative fees and a home appraisal.

• HELOCs have the potential for the lowest closing costs. This is because you are not taking out a new loan. The lender adds the HELOC to your existing mortgage as a second lien.
• A cash-out refinance typically has higher closing costs than a home equity loan. This is because you are taking out a new loan with closing costs associated with a new mortgage.
• A home equity loan typically has lower closing costs than a cash-out refinance. The lender may allow you to roll the closing costs into the loan.

Funding Speed

The funding speed is how quickly you can receive loan funds after completing the application process.

• HELOCs have the potential to fund the fastest. The lender adds the HELOC to your existing mortgage as a second lien.
• A cash-out refinance typically has a longer funding timeline than a home equity loan. This is because you are taking out a new loan which takes time to process.
• A home equity loan typically has a longer funding timeline than a HELOC. This is because the lender may require a home appraisal which can take time to schedule and complete.

Tax Implications

The interest on a HELOC, home equity loan, and cash-out refinance may be tax deductible. The IRS allows you to deduct the interest paid on up to $750,000 of mortgage debt. This limit applies to all mortgages obtained after December 15, 2017.

The interest is usually tax deductible if you use a HELOC, home equity loan, or cash-out refinance to buy or improve a primary residence. If you use these loans to purchase or improve a second home, the interest is usually not tax deductible.

You should speak with a tax advisor to determine if the interest on your loan is tax deductible.

Current Interest Rates

If market interest rates have risen since your initial mortgage, you may want to avoid changing it. If your mortgage has been locked in through a fixed rate, you can save money by keeping the lower interest rate. If this is the case, it's best to avoid making significant changes to your primary mortgage with a cash-out refinance. You could save money through a HELOC or home equity loan to avoid refinancing into higher interest rates.

However, if market interest rates have fallen since your initial mortgage, you may want to consider refinancing to get a lower interest rate. This is especially true if you have a fixed-rate mortgage.

Application Process

The application process for a HELOC, home equity loan, and cash-out refinance is similar. You'll need to submit information about your employment, income, debts, and assets. The lender will use this information to determine if you qualify for the loan and how much they're willing to lend you. You may also be required to submit a home appraisal. This is to ensure the property can be collateral for the loan and help the lender determine how much they're willing to lend you. At a minimum, most lenders want to see the following criteria:

• Minimum credit score of 620
• Maximum combined loan-to-value ratio of 80% to 85%
• Maximum debt-to-income ratio of 43%

Once you've submitted your application, the lender will review your information and decide. If you're approved, you'll receive a loan offer. The offer will include the loan terms, interest rate, closing costs, and repayment schedule. You can then decide if you want to accept the loan or not.

Comparing Loan Offers

Now that you know how to apply for a loan, here are some tips on comparing offers and what to look for in a lender.

When you're ready to compare offers, look at the annual percentage rate (APR). The APR includes the interest rate plus any fees charged by the lender. The APR will give you a better idea of the loan's actual cost.

You should also compare the loan terms. Loan terms can vary from 5 years to 30 years. A shorter loan term will have higher monthly payments, but you will pay less interest in the long run.

Finally, make sure to compare the withdrawal schedule. The withdrawal schedule is the schedule of how and when you can access the loan funds.

The Bottom Line

HELOCs, home equity loans, and cash-out refinances offer different ways to access the equity in your home. A HELOC is a revolving line of credit. This means you can borrow money as you need it up to your credit limit. A home equity loan is a lump sum loan with a fixed interest rate. This means you get the entire loan and make fixed monthly payments at once. A cash-out refinance is a new mortgage that replaces your current mortgage and allows you to take cash out of your equity.

All three options are typically used for home improvements or to consolidate debt. But, each option has different benefits and drawbacks. Make sure to compare offers from multiple lenders to find the best loan for you. Consider the APR, loan terms, and withdrawal schedule when comparing offers.