As a homeowner, you may have heard about two ways to tap into your home equity: a home equity line of credit (HELOC) or a cash-out refinance.
Both options allow you to access the equity in your home to pay for expenses such as home improvements, debt consolidation, education expenses and so on.
What's in this article?
A HELOC is a revolving line of credit that allows you to borrow money as needed—up to a predetermined limit—then pay it back over time. It works like a credit card, with a variable interest rate and a monthly payment based on the outstanding balance.
On the other hand, a cash-out refinance allows you to replace your current mortgage with a new one—borrowing more than you currently owe—then receiving the difference in cash.
In this article, we’ll provide you with a comprehensive guide to HELOCs and cash-out refinances, including the advantages and disadvantages of each option, as well as a comparison of key factors to consider when deciding which option to choose.
By the end, you should better understand the benefits and risks associated with each option and be better equipped to make an informed decision about which one is right for you.
What is a home equity line of credit (HELOC)?
A HELOC is a second mortgage, while a cash-out refinance is replacing your old loan with a new one. The HELOC loan allows you to borrow money against your home’s equity.
Equity is the difference between the current value of your home and the amount you owe on your mortgage. A HELOC gives you a credit limit based on this amount which you can draw from as needed and pay back over time.
How does HELOC work?
When you apply for a HELOC, the lender will assess your creditworthiness, the value of your home and the amount of equity you have. If approved, you will be given a credit limit which is available to you at any time during the draw period (usually 5-10 years).
During this time, you must make minimum payments based on the outstanding balance, mainly the interest on the loan.
After the draw period ends, you will enter the repayment period, during which you’ll be required to pay back the principal balance plus interest over a fixed term (usually 10 years).
Your interest rate may be variable or fixed, depending on the terms of your HELOC. Homeowners often have to pay loan processing, origination, appraisal and recording fees when applying for a HELOC, all of which is comparable to the process for any home refinance.
You can also increase your HELOC limit. The procedure for raising a HELOC’s limit differs by lender, just like the process for HELOC applications and the required fees. However, most lenders allow borrowers to request an increase in the total amount.
The outstanding HELOC balance is refinanced into a larger HELOC with updated terms and conditions, a new interest rate and updated draw and payback periods if the lender accepts the increase.
Learn how home equity can be used for many reasons—including paying off debts.
Advantages of HELOC
HELOCs can be a good option for homeowners with equity in their homes who want flexibility and cost-effective access to funds. Let’s look at the advantages:
- Flexibility: You can use the funds as needed and only pay interest on the amount you borrow. HELOCs may also have lower interest rates than other forms of credit, such as credit cards or personal loans, making them a cost-effective option for accessing funds.
- Tax benefits: The interest on HELOCs is usually tax-deductible if you use the funds for home improvements or renovations, making them a popular choice for homeowners looking to finance home projects.
- Continued access: HELOCs can also be a good option for those who need ongoing access to funds for large expenses (such as education expenses or medical bills) and who want to be able to borrow money as needed.
Disadvantages of HELOC
While HELOCs can be a useful tool for accessing funds, they also come with risks and should be carefully considered before taking one out. It’s important to understand the terms and conditions of the loan, including the interest rate, fees, repayment period and repayment plan. Here are some disadvantages:
- Variable interest: One of the main disadvantages of a HELOC is that the interest rate is typically variable, meaning that it can fluctuate over time. This can make it difficult to predict future payments and may result in higher monthly payments.
- Lender freeze: The lender can also freeze or reduce the credit limit of your HELOC if there is a decline in the value of your home or a change in your creditworthiness. This can limit your access to funds and make planning for future expenses difficult.
- Risk of foreclosure: Because your home secures a HELOC, if you fail to make payments, the lender may foreclose on your home, putting you at risk of losing your property.
Learn the difference between home equity loans and HELOCs.
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What is a cash-out refinance?
A cash-out refinance is a type of mortgage refinancing that allows you to borrow more than your current mortgage balance and receive the difference in cash.
The cash you receive can be used for various purposes, such as home renovations, paying off high-interest debts or other major expenses.
How cash-out refinance works
When you apply for a cash-out refinance, you must go through the same process as when you originally obtained your mortgage. You must provide documentation such as income verification, credit score and other financial information to the lender.
If approved, the lender will provide you with a new mortgage with a higher balance than your current one. You will receive the difference in cash, and you can use that cash for whatever expense you determine.
Advantages of Cash-Out Refinance
- Lump sum cash: Cash-out refinancing is attractive because it can give you access to a large sum of money at a lower interest rate than other forms of credit, such as personal loans or credit cards. By consolidating high-interest debts into your mortgage, you may be able to save money in interest payments over time.
- Tax-deductible: Another advantage of cash-out refinancing is that the interest on the loan is usually tax-deductible if you use the funds for home improvements or renovations, making it a popular choice for homeowners looking to finance home improvements.
- Lower your rate: Additionally, cash-out refinancing can be a useful tool for homeowners looking to take advantage of lower interest rates. It allows them to refinance their existing mortgage and obtain a lower interest rate while accessing funds.
Disadvantages of Cash-Out Refinance
- Extend payment period: A cash-out refinance increases the debt you owe on your home and may extend the time it takes to pay off your mortgage. This can result in higher overall interest payments over the life of the loan.
- Fees: Another disadvantage of cash-out refinancing is that it may come with fees and closing costs which can be expensive. These fees can add up to thousands of dollars and may offset some of the benefits of refinancing.
- Risk of foreclosure: Additionally, if you cannot make your mortgage payments, you risk losing your home to foreclosure as your property secures the loan.
Comparing Home Equity Line of Credit and Cash-Out Refinance
When deciding between a HELOC and cash-out refinance, several factors must be considered. These include:
- Your financial goals
- The amount of equity you have in your home
- Your credit score
- Ability to make monthly payments
A cash-out refinance may be a better option if you need access to a large sum of money. Nonetheless, a HELOC is an appropriate choice if you only need to borrow a smaller amount and want more flexibility in how you use the funds.
However, when deciding between a HELOC and cash-out refinance, it’s important to carefully consider factors unique to your situation and choose the option that better meets your financial goals and needs.
It’s also important to work with a reputable lender like Compass Mortgage, who can help you understand the terms and conditions of each loan and make an informed decision. Consider the following when choosing between the two.
Compare interest rates
HELOCs typically come with variable interest rates, meaning the interest rate may change over time. On the other hand, cash-out refinances generally come with fixed interest rates which remain the same for the life of the loan.
Variable interest rates may be lower initially but can increase over time, resulting in higher overall interest payments. Fixed interest rates may be higher initially but provide greater stability and predictability in your monthly payments.
Compare fees
Both HELOCs and cash-out refinance may come with fees and closing costs, and those costs can vary depending on the lender and the loan terms. HELOCs typically come with lower fees than cash-out refinances but may also come with annual fees or other costs over time.
Cash-out refinances typically come with higher closing costs, including appraisal fees, loan origination fees and other charges associated with refinancing your mortgage. These fees can add up to thousands of dollars and may offset some of the benefits of refinancing.
Compare loan terms
HELOCs typically come with a draw period, during which you can borrow funds and make interest-only payments. After the draw period ends, you must begin paying the principal and interest payments.
On the other hand, cash-out refinances come with a fixed repayment period, during which you will need to make regular monthly payments on both the principal and interest. This can make planning and budgeting for your payments easier over time.
Determine the risk
Both HELOCs and cash-out refinances come with risks. With a HELOC, the interest rate is variable and can increase over time, resulting in higher overall interest payments.
With a cash-out refinance, you are taking on more debt and extending the time to pay off your mortgage. This can result in higher interest payments over time.
Additionally, if you cannot make your mortgage payments, you risk losing your home to foreclosure as your property secures the loan, again, with either option.
How to choose between HELOC and cash-out refinance
Home equity lines of credit (HELOC) and cash-out refinances are both great options for homeowners needing to access home equity.
Ultimately, your decision on whether to choose a HELOC or a cash-out refinance will depend on your financial circumstances and goals. If you need to borrow a smaller amount and want more flexibility in how you use the funds, a HELOC could be a more desirable alternative.
However, a cash-out refinance may be a better choice if you need access to a larger sum of money and want to replace your existing mortgage.
Whether HELOC or cash-out refinance take the next steps with Compass Mortgage
If you’re tired of feeling overwhelmed by debt, one of these popular options may be the solution you’ve been looking for.
Contact Compass Mortgage today to learn how we can help you achieve your financial goals.
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