Homeowners seeking to cash in their home equity have several options, including cash-out refinancing and home equity lines of credit (HELOCs). While both can be beneficial, they serve different purposes, have varying interest rates, repayment methods, and associated risks.
In this guide, our team of mortgage experts will explain how each works and help you decide which option best fits your needs, such as renovations, debt consolidation, or ready money for urgent expenses.
What’s the Difference Between a Cash-Out Refinance and a HELOC?
While both options allow you to benefit from your home equity, they work differently. A cash-out refinance replaces your existing mortgage with a new, larger loan. In contrast, a HELOC is a line of credit that uses your property as collateral.
Both a cash-out refinance and a HELOC are new mortgages, but a HELOC works more like a credit card that is secured by your home’s equity. They also differ in interest rates, repayment periods, and closing costs.
| Cash-Out Refinance | HELOC | |
| Payment Method | Lump sum | Revolving line of credit |
| Interest Type | Fixed interest rate | Variable interest rate |
| Repayment Terms | Fixed monthly payments | Starts with interest only and then moving to principal and interest |
| Repayment Starts | Immediately | Interest-only until repayment period |
| Closing Costs | Similar to a first mortgage | Lower than a refinance or first mortgage |
What Is a Cash-Out Refinance?
A cash-out refinance is a new, larger mortgage that replaces your current mortgage. It is based on the home’s current assessed value rather than its original purchase price. If you have been making monthly mortgage payments and the house has appreciated in value, then you will have equity that you can leverage through cash-out refinancing.
You will receive the difference between your home’s original and current value as cash, which you can then use for home repairs, emergency debt relief, or a down payment on a new property.
Please note that, as this is a new loan, you may have different interest rates, terms, and monthly mortgage amounts.
How a Cash-Out Refinance Works
Let’s assume that your home is worth $500,000, and your mortgage is $250,000. This means there is $250,000 of equity in your home.
Mortgage lenders typically expect an 80% loan-to-value ratio, meaning that you can only borrow 80% of your home’s total value. In this instance, your maximum loan would be $400,000.
We will then subtract the existing mortgage balance, which gives a total cash-out refinance amount of $150,000.
Pros and Cons of a Cash-Out Refinance
Cash-out mortgage refinancing can be a great option for some borrowers, while it may cause issues for others. You can often get a better interest rate than with your old mortgage, especially if you bought your home during historically high interest rates.
Fixed rates mean predictable monthly payments, which makes financial planning easier. Those who are consolidating debt or paying for home renovations can benefit from lower interest rates than personal loans.
However, this refinancing option does have some risks. You may have higher closing costs than for your original mortgage because the total loan is larger. You’ll have a higher debt-to-income ratio, which can make it harder to open other credit lines. Additionally, this new mortgage restarts the mortgage clock, meaning you’ll be paying off your home for a longer period.
What Is a HELOC?
A Home Equity Line of Credit (HELOC) is a second mortgage with a revolving credit line, similar to a credit card. You take out an entirely new loan in addition to your original loan, meaning you are making two mortgage payments.
Like a cash-out refi, you can borrow money up to a certain percentage of your home’s equity. However, you only borrow as much as you need to over time. This makes it different than a home equity loan, where you can receive payments in monthly installments or as a lump sum.
In general, there is a draw period, during which you make interest-only payments, followed by a repayment period where you are responsible for the outstanding balance.
How a HELOC Works
A HELOC has two periods: a draw period, typically 5-10 years, and a repayment period of 10-20 years, depending on your loan terms.
Let’s assume that you are completing large-scale renovations on your home. You realize that you may need more money in the future, so you opt to open a home equity line of credit. During the first 5-10 years, you can draw down money from your available credit. You’ll pay your primary mortgage and make minimum payments on the home equity line of credit, usually just the interest amount.
Once the draw period ends, you’ll continue making monthly payments on your old loan, and you will also make additional payments on your HELOC that cover both interest and the balance.
Pros and Cons of a HELOC
A home equity line of credit can be a better option than a cash-out home loan or a home equity loan because it offers more flexibility. Rather than getting a lump sum payment, you can draw down funds as necessary.
However, there are some disadvantages to a HELOC. The first is that HELOCs usually have variable mortgage rates. This means that your rates may increase in the future.
HELOCs have the same risk as a credit card; namely, you may overspend because you’re not spending physical cash. Because your home is used as collateral, the lender has the first lien position if you default, and you may lose your home.
Which Option Offers Lower Interest Rates?
While you can get competitive interest rates on either of these loan options, their interest structures differ. Cash-out refinances are typically fixed-rate loans, while HELOCs are variable-rate home loans.
Your interest rate will depend on your credit history and loan-to-value ratio. If you have the minimum credit score required, then you will have to pay the highest rates. Similarly, if you have a very high loan-to-value ratio, you will have to pay more.
Loan Terms and Repayment Schedules
A cash-out refinance has a standard mortgage repayment schedule. When you open this new loan, you close your old loan and commit to monthly payments.
In contrast, a home equity line of credit has an interest-only payment phase, where you are just required to pay the accrued interest. After this drawdown period, which typically lasts 5-10 years, you will be required to pay both the interest and the principal. This loan structure can cause payment shock, so it’s essential to plan carefully and be prepared for the higher payments.
Fees and Closing Costs to Consider
Cash-out refinances typically have higher closing costs than a HELOC or an original mortgage. Lenders require a new appraisal, origination fees, underwriting fees, and closing costs.
While HELOCs typically have lower closing costs, you may have to pay an annual maintenance fee. You may also be penalized if you decide to close the HELOC early and begin repayment.
How Much Can You Borrow With Each Option?
Most lenders have an 80-85% loan-to-value (LTV) limit for cash-out refinances and home equity lines of credit (HELOCs). Each lender is slightly different, and they may offer lower limits depending on your home value and mortgage balance.
Tax Implications for Cash-Out Refinance and HELOC
Firstly, the sum you receive from a cash-out refinance is not taxable income because it comes from a loan.
According to the Internal Revenue Service, interest paid on a cash-out refinance or HELOC is tax-deductible regardless of how you use the proceeds. Previously, it was only deductible if you used the home loan for qualifying expenses, like home improvement. You should work with a tax preparer to itemize deductions and ensure that you do not overpay.
Which Option Is Better for Home Renovations?
Both these loans can be very helpful for home improvement, but which one you choose depends on how your project is structured and what expenses you expect to pay.
If you are performing a large one-time project, such as renovating your kitchen, then a cash-out refinance would be a good option because it provides a lump sum you can provide to your contractors.
HELOCs are a good option if you have a phased project where all the expenses are not yet known, or if there are significant and ongoing renovations.
Using Home Equity for Debt Consolidation
While these loans can be a tempting option for debt consolidation, you must carefully consider whether you’re willing to secure debt with your primary residence. If your other debts are unsecured, and you end up in default, then you may lose your home.
Credit Score Requirements and Approval Process
For a refinance, you typically need a credit score of 620 or higher and a debt-to-income (DTI) ratio below 50%. You should also have at least 20% equity in your home after the refinance. The approval process takes between 30 and 60 days.
HELOCs typically have more stringent credit requirements. You will need a score of 680 or higher and a DTI no higher than 43%. However, HELOCs generally are funded faster, in anywhere between 14 and 45 days.
Risks of Tapping Into Your Home Equity
While home equity can be a useful tool, you risk foreclosure if you fail to repay the loan. You should also only borrow what is necessary, as a larger loan drains more of your equity.
With HELOCs, you may find yourself paying more than you expected due to rising rates. Additionally, a refinance resets the clock on your mortgage, potentially meaning you are paying off your home for decades longer.
When to Choose a Cash-Out Refinance vs a HELOC?
A cash-out refi is a good option if you would like to lock in low rates. You can also use this mortgage option for one-time renovations, down payments on a second home, or consolidating high-interest debt.
In contrast, a HELOC is a good option if you need flexible funding, such as ongoing maintenance and repairs for your property.
FAQs About Cash-Out Refinance and HELOCs
Is a HELOC or cash-out refinance better for home improvements?
This depends on what type of home improvements you’re doing. A HELOC is good if you have a phased, long-term project where you’re not sure how much funding you’ll need overall. A refinance is good if you have a one-time project with set expenses.
Can I get a HELOC or cash-out refinance with an FHA or VA loan?
Both the FHA and VA mortgage programs allow for refinancing, including cash back options. However, neither program directly offers HELOCs. You would need to secure a line of credit from a private lender, using your home as collateral.
Will tapping into home equity hurt my credit score?
Because opening a mortgage requires a hard credit inquiry, you will notice a temporary dip in your score. A refinance also raises your overall debt, which can drop your score. However, if you improve your home value or eliminate high-interest debt, you may see credit improvements.