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 that can be accessed on an as-needed basis, up to the borrowing limit. The borrower is only charged interest and is 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, 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 generally 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.
Read on to 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 a line of credit that borrowers can draw from using their home as collateral. The amount of the line of credit is determined by the mortgage lender and 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 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 must 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 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. During the repayment period, on the other hand, the payments can increase significantly because both principal and interest have to be paid.
Recommended: How Do Home Equity Lines of Credit Work?
A cash-out refinance is a form of mortgage refinancing that allows a borrower 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 still only have to make one monthly payment. Another key difference of a cash-out refinance vs HELOC is that a cash-out refinance may have a fixed interest rate, meaning the interest rate remains unchanged for the life of the loan. This means monthly payments remain the same. Additionally, interest rates are typically lower with a cash-out finance vs 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
Here’s a look at how HELOC and cash-out refinance stack up when it comes to everything from the borrowing limit to the interest rate to the fees:
|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 an 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 It Might 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 whether a HELOC vs. a cash-out refinance 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 rate, 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 an 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 get 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.
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.
Recommended: The Different Types Of Home Equity Loans
Cash-out refinancing and HELOCs both have their place in a borrower’s toolbox. 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.
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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