Cash-Out Refinance vs. Home Equity Line of Credit (HELOC)
If you own your own home, you've probably built up some valuable equity over the years, and you might be considering how to use it for important things like home improvements, paying off debt, or achieving a big life goal.
The challenge? Deciding between a cash-out refinance and a Home Equity Line of Credit (HELOC).
The best choice depends on your financial needs and goals. This article will guide you through everything you need to know about HELOCs and cash-out refinancing so you can determine which mortgage refinance loan works best for you.
Already made your decision? Check out either Rate's HELOC or cash-out refinance options depending on what you prefer!
What is a HELOC and How Does It Work?
A Home Equity Line of Credit (HELOC) offers a flexible credit line that allows you to access your home's equity. It works much like a credit card, enabling you to borrow money repeatedly within a set limit.
Unlike traditional loans that offer a lump sum, a HELOC gives you a line of credit during the "draw period," that typically lasts 5 to 10 years. During this time, you can make interest-only payments on the amounts you withdraw.
The "repayment period" that follows, which can last between 10 to 20 years, during where you’ll repay both the principal and the interest. This option is particularly helpful for covering expenses like home improvements or unexpected costs.
However, keep in mind that during the repayment period, your monthly payments could increase significantly, so planning ahead is essential.
HELOC Benefits and Risks
Benefits
A HELOC offers unique home loan advantages that can make it a smart choice for many homeowners:
Debt Consolidation
HELOCs can help you manage high-interest debt, like credit cards or personal loans, by consolidating them into one lower interest payment.
Investment Opportunities
If you’re funding an investment, like buying a rental property or a small business, a HELOC provides flexible funds that you can use strategically as opportunities arise.
Tax Advantages
HELOC interest may be tax-deductible, especially for home improvement projects, which could also increase your home’s value.
Emergency Access to Funds
A HELOC serves as a financial safety net for unplanned expenses, like medical bills or urgent home repairs. The ability to draw funds when needed means you’re not paying interest on money you don’t use.
Risks
While HELOCs are flexible, there are risks to keep in mind before borrowing:
Rising Interest Rates
Most HELOCs come with variable interest rates, meaning your monthly payments can go up if interest rates rise.
How to Protect Yourself: Consider a loan that lets you lock in a fixed rate. This can provide more predictable monthly mortgage payments and peace of mind.
Borrowing Too Much
Since HELOCs give you ongoing access to funds, it’s simple to overspend or borrow for things that don’t add value, like vacations or luxury items. You may end up with too much debt and risk foreclosure.
How to Stay on Track: Borrow only what you need and can afford to repay comfortably and stick to a clear financial plan.
Impact on Home Equity
Every time you borrow from your HELOC, you reduce the amount of equity in your home. If your home value declines, this could leave you with less financial flexibility or even owing more than your home is worth.
How to Mitigate This: Be mindful of how much you’re borrowing and avoid using your HELOC for expenses that won’t provide a long-term benefit to your financial situation.
Types of HELOCs Available
HELOC loans come in two mortgage types: fixed-rate and variable-rate. With a variable-rate HELOC, your interest rate is often tied to the prime rate and can change over time. This means that your payments will change from time to time.
A fixed-rate HELOC, on the other hand, gives you security with steady monthly payments, but you may not be able to change the terms as easily.
Which one you choose depends on how comfortable you are with changes to your payments. While a variable rate could potentially save you money, it may not be the best option for you if you prefer having a more structured approach.
HELOC Requirements
For a Home Equity Line of Credit (HELOC), lenders usually look at a few key factors:
Credit Score
Most lenders want applicants to have a credit score of at least 680, but some may look at people with scores as low as 620.
Debt-to-Income (DTI) Ratio
Lenders usually want a DTI ratio of 43% or less, which means that your monthly debt payments should not be more than 43% of your gross monthly income.
Home Equity
You should have at least 15% to 20% equity in your home. This means your mortgage HELOC debt shouldn’t exceed 80% - 85% of your home’s current market value.
What is a Cash-Out Refinance and How Does It Work?
A cash-out refinance is a way to use the value of your home to your advantage by changing your current mortgage with a bigger one and getting cash upfront.
This option allows you to take the cash difference between your new loan and the remaining balance of your original mortgage for major expenses like home improvements, paying off other debt, or education.
However, it's important to know how interest rates affect this process. While securing a cheaper rate can save you money every month, refinancing may not be worthwhile if current rates are higher than your original mortgage rate.
If you refinance with a bigger loan balance, your monthly mortgage balance might go up, even if you can get a cheaper rate. This means you should consider how your budget may change and how it will affect your finances long-term.
For example, if you want to extend your loan term after nearly finishing your original mortgage payment, the total interest you pay could increase.
Benefits and Drawbacks of Cash-Out Refinance
Benefits
Access to a Lump Sum of Cash
You can use cash-out refinancing to quickly access a large amount of money, which can be used for major expenses like home renovations, paying off high-interest debt, or education financing.
Potential for Lower Interest Rates
If market rates are lower than the rate on your existing mortgage, a cash-out refinance allows you to replace your old loan at a reduced rate. This could lead to bigger savings over the life of the loan.
Flexible Options for Borrowers with Low Credit
Even if you have less-than-perfect credit, some lenders offer refinancing programs tailored to homeowners in your situation. While the rate might be higher, this option still unlocks the equity in your home to help meet financial goals.
Drawbacks
Higher Long-Term Interest Costs
Extending the loan term by refinancing can increase the total interest paid over the life of the loan.
How to Minimize This: To minimize long term costs, consider getting a cash-out refinance loan with a shorter term, like 15 or 20 years. While your monthly payments may be higher, you’ll save money on interest.
Closing Costs Can Add Up:
Refinancing typically comes with closing costs that range from 2% to 6% of the loan amount. While some lenders offer “no-closing-costs” options, these often come with higher interest rates.
How to Manage This: Shop around for lenders that offer competitive refinance rates and closing costs. If you need to preserve cash upfront, ask about rolling these costs into the loan.
Risk of Over-leveraging
Taking on a larger mortgage increases your debt and reduces your home equity. If your property value declines, you could end up owing more than your home is worth, making it difficult to sell or refinance later.
How to Protect Yourself: Borrow only what you truly need and ensure your loan-to-value (LTV) ratio stays within manageable limits. Aim for an LTV of 80% or less to leave a financial cushion.
No Closing Fee Refinance Options
Some lenders let you refinance with no closing costs, which means they pay for the costs up front. This may sound good, but keep in mind that the interest rate is usually a little higher.
This choice can help you keep your cash in hand while lowering your out-of-pocket costs.
Low Credit Refinance Options
There are refinancing programs specifically for borrowers with lower credit scores.
Cash-out refinancing could still be a beneficial way to get access to your home's wealth, even if you have bad credit and the interest rate is higher.
You might find favorable terms by shopping around.
Refinance Requirements
To qualify for a cash-out refinance, you need to meet certain financial criteria that demonstrate your ability to manage the new loan responsibly. These requirements include:
Credit Score
Most conventional loans need a credit score of at least 620, but some programs may accept credit scores lower than that.
Home Equity
Your loan-to-value (LTV) number shouldn't be more than 80%, which means you should have at least 20% equity in your home.
Debt-to-Income (DTI) Ratio
Lenders like a DTI ratio of 43% or less, which means that your monthly debt payments should not be more than 43% of your gross monthly income.
Choosing Between a HELOC and Cash-Out Refinance
When thinking about whether to get a HELOC or a cash-out refinance, consider your monthly income, current mortgage interest rates, and financial goals to figure out which choice fits your real estate needs the best.
Rate offers both options, and we can also help you in making choices that fit your budget and lifestyle. Apply for Rate's HELOC or Cash-Out Refinance to help you get the most out of your home today!
*Rate, Inc. does not provide tax advice. The consumer should always consult a tax advisor for information regarding the deductibility of interest and other charges in their particular situation.
**Savings, if any, vary based on the consumer’s credit profile, interest rate availability, and other factors. Contact Rate, Inc. for current rates. Restrictions apply.