Cash-out refinances and home equity lines of credit are two borrowing options that allow homeowners to tap into the equity they have built in their home.
A HELOC is a line of credit secured by the borrower’s home. The line of credit can be accessed on an as-needed basis, up to the borrowing limit. The borrower is only charged interest and responsible for repaying the amount they actually borrowed.
For a cash-out refinance, the borrower takes out an entirely new mortgage while borrowing a portion of their existing home equity. The total borrowed amount of the cash-out refinance will be greater than the borrower’s original mortgage, and the borrower will receive the difference in a lump sum payment from the lender.
So while both allow borrowers to access the equity they’ve developed, a HELOC operates as a revolving line of credit that is secured by the borrower’s home, while a cash-out refinance offers a lump sum amount when the borrower refinances their home, resulting in an entirely new mortgage.
There are differences in how each type of loan works that may influence which is right for you. In general, HELOCs give borrowers flexibility since they can draw on the line of credit as needed and are suited for shorter-term financial needs. Cash-out refinances require the borrower to take out a new mortgage and the borrower generally needs to pay closing costs upfront. They often have a fixed interest rate and may be a better option for borrowers who have a long-term need.
Learn more about the pros and cons of a HELOC vs a cash-out refinance.
Difference in HELOCs and Cash-Out Refinancing
Home Equity Line of Credit (HELOC)
A HELOC is like a line of credit in that borrowers 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 usually 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 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 may have a fixed interest rate, meaning that the interest rate remains unchanged for the life of the loan so the monthly payments remain the same. Additionally, interest rates are typically lower than with a HELOC.
Recommended: Home Buyer’s Guide
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.
HELOC vs Cash-Out Refinance
|Borrowing Limit||80% to 90% of borrower’s equity||80% of borrower’s equity|
|Interest Rate||Generally variable||May be fixed or variable|
|Type of Credit||Revolving Credit
Borrowers receive a line of credit for a specified amount and draw period (5 to 10 years) followed by a repayment period (10 to 20 years).
Borrowers receive a lump sum payment. The resulting mortgage has a new rate and repayment terms (generally 15 to 30 years).
|Fees||Several types of fees, depending on the loan terms, may be charged periodically such as an annual fee or inactivity fee for non-usage.||Fees are generally paid upfront in the form of closing costs (typically 3% to 5% of the loan amount)|
|When might it make sense to borrow?||HELOCs can be useful for shorter-term needs or situations where a borrower may want to access funds over a specified period of time||Cash-out refinances may be useful if borrowers need a large sum of money that is often used to improve their financial situation on the whole (for example to pay off debt or to finance a large home improvement project).|
Which is Better?
Like most things in the world of finance, the answer to which option is better will vary by person based on their individual financial circumstances and unique needs. In some situations, a HELOC may make more sense than a cash-out refinance and vice versa.
Because HELOCs generally have a variable interest, they can be useful for shorter-term needs or situations where a borrower may want access to funds over a certain period of time, for example when completing a home renovation.
Cash-out refinances can make sense if there is a need for a large sum of money or if they can be used as a tool to improve your financial situation on the whole.
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. One 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 potentially 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.
Both cash-out refinancing and HELOCs have their place in a borrower’s toolbox. In both cases, borrowers are borrowing against the equity they have built in their home, which comes with risks. In the case that a borrower is unable to make payments on their HELOC or cash-out refinance, the consequence could be selling the home or even losing the home to foreclosure.
HELOCs are a revolving line of credit that are generally used when a borrower has shorter-term financial needs. Borrowers are able to draw against the line of credit as needed however the interest rate is variable. Cash-out refinances are generally used for longer term needs and often have a fixed interest rate.
Home owners interested in tapping into their home equity may want to consider cash-out refinancing with SoFi.
Qualifying borrowers can secure competitive rates and mortgage loan officers are available to walk borrowers through the entire process.
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