Cash-Out Refinance vs Home Equity Line of Credit
For most Americans buying a home is the biggest purchase they’ll ever make and the largest asset they’ll ever own. Houses are illiquid assets, meaning that in order for a homeowner to receive cash from the equity they have built they need to sell the home. This is why mortgage lenders have found creative ways to help borrowers tap into their home’s equity by either taking out a home equity line of credit (HELOC) or by completing a cash-out refinance of their current mortgage.
Either option gives a borrower access to funds that they can use for many purposes such as to cover a medical emergency, major home repair, or even to consolidate higher interest credit card debt.
Home Equity Line of Credit (HELOC)
A HELOC gives a borrower access to a line of credit that they can draw from using their home as collateral. The amount of the line of credit is determined by the mortgage lender and is based on the amount of equity a homeowner has built. Lenders usually limit the line of credit to around 80% to 90% of the equity amount.
A unique feature of a HELOC is that it works somewhat like a credit card in that it is revolving. If a borrower, for example, is approved for a $30,000 home equity line of credit, they can access it when they want for the amount that they choose by writing a check or even using a specified credit card. Many lenders, however, have a minimum draw requirement, which means a borrower has to take out a minimum amount even if it’s more than they need at the time. Also, lenders have the right to change the terms associated with the line of credit and can even close it, often without having to provide advanced notice.
A major drawback of a home equity line of credit is that the interest rate is adjustable. This means that the interest rate can rise, and if it does, the monthly payment can increase. Another point that borrowers should keep in mind is that there is a draw period of 5 to 10 years during during which a borrower can access funds and a repayment period of 10 to 20 years. During the draw period, the monthly payments can be relatively low because the borrower pays interest only, but during the repayment period, the payments can increase significantly because both principal and interest have to be paid.
A cash-out refinance is a form of mortgage refinancing that allows a borrower the ability to refinance their current mortgage for more than what they currently owe in order to receive extra funds. For example, if a borrower owns a home worth $200,000 and owes $100,000 on their mortgage at a high interest rate, they could refinance at a lower interest rate, while at the same time taking out a larger mortgage. Let’s say they refinance the mortgage at $130,000. In this case, $100,000 would replace the old mortgage, and the borrower would receive the remaining amount of $30,000 in cash.
Borrowers should keep in mind that a cash-out refinance replaces their current mortgage and even though they receive additional cash they only have to make one monthly payment. Unlike a home equity line of credit, a cash-out refinance can have a fixed interest rate for the life of the loan so the monthly payments remain the same. Additionally, interest rates are typically lower than with a HELOC.
The approval process for a cash-out refinance is similar to the initial approval process when buying a home. It can be somewhat cumbersome, but the payoff is a lower interest rate, a fixed payment, and access to additional cash.
Both a home equity line of credit and a cash-out refinance have fees associated with them. With a cash-out refinance, fees are paid upfront in the form of loan closing costs. With a HELOC, several types of fees can be charged periodically such as an annual fee or inactivity fee for non-usage. The best way for a borrower to reduce these fees is to shop around and compare lenders.
While it’s typically faster to be approved for a home equity line of credit, the adjustable interest rate and lack of a fixed payment can be a drawback. The approval process for a cash-out refinance is more complex than that of a HELOC, but the loan will have a set payment and a lower interest rate that can provide significant savings. Both options give borrowers the ability to turn their home equity into cash, which can make it possible to achieve certain goals, consolidate debt, and improve their overall financial situation.