“Both cash-out refinance and HELOC or Home Equity Lines of Credit can be excellent options to consider when planning to access the equity in your home. However, besides being effective, both cash-out refinance and HELOC have their pros and cons as well. This means that depending on your needs and circumstances, one method might turn out to be better than the other. This article discusses everything that you must know about to critically evaluate both cash-out refinance vs HELOC.”
Indeed, there isn’t any doubt in saying that investment in real estate is one of the most rewarding decisions in life. And this is not just valid about the real estate held as an investment. Owning even the home that you live in is also an investment that accumulates equity over the years.
Hence, when the need arises or when you think your home has accumulated enough equity, why not tap into this opportunity, and unlock other dreams of your life. In simple words, why not transform the increase in your home’s value or equity into some cash funds to utilize them to accomplish something better and more meaningful in life.
Cash-out refinance and HELOC are two of the most popular ways to access your home’s equity and turn it into cash. Homeowners commonly use both methods to finance their other projects or ambitions such as paying off their other debts, especially those bearing high-interest rates, and doing home repairs, renovations, and improvements.
But while both these options may seem to be equally rewarding, they do have some key differences between them. Understanding these differences is integral to making the right decision in your case between cash-out refinance vs HELOC.
Cash-out refinance vs HELOC or home equity lines of credit
Before moving forward, it is important to understand an important term used repeatedly in this article. The following statement briefly explains the term ‘equity’ and what it comprises.
“Equity is the dollar amount of your home’s value less any outstanding amount of your mortgage on the same home.” In other words, it means that with each subsequent mortgage payment, you gain further equity in your home.
For instance, you bought a home for $500,000 through a mortgage. Then after a few years of repayments, your current outstanding mortgage amount stands at $250,000. Now, if the market value of your home today is $550,000, your resulting equity stands at $300,000 ($550,000 less $250,000). In other words, you have accumulated total equity of $300,000 in your home.
Remember that both cash-out refinance and HELOC are home equity methods to capitalize or convert a portion of your home equity into cash funds.
Now let us further discuss our main topic of cash-out refinance vs HELOC.
What is a cash-out refinance?
A cash-out refinance is a method of accessing home equity by allowing a homeowner having accumulated some equity in their home to obtain a new and larger mortgage. The amount of this new mortgage is more than the amount of the previous mortgage that is still outstanding.
By taking a new and larger loan, the homeowner settles the previous outstanding mortgage. This simply means that the new loan replaces the old outstanding mortgage.
The homeowner in this transaction benefits from the difference between the two mortgages minus closing costs. In other words, the homeowner receives the cash difference that remains after paying the old mortgage from the new one minus closing costs.
Remember that cash-out refinance comes in the form of a single lump-sum amount. Therefore, if you currently do not need to spend all the cash amount received, then perhaps opting for cash-out refinancing may not be suitable in your case.
Similarly, a cash-out refinance could be a good option in case of a lower interest rate. This means getting a lower interest rate than what you are currently paying on the existing outstanding mortgage. However, if this is the opposite and you expect to pay a higher interest rate than what you are currently paying, cash-out refinancing will not be feasible.
What is a HELOC or home equity line of credit?
Contrary to the above, a HELOC or home equity lines of credit method work in the opposite manner.
A HELOC or home equity line of credit works as a second mortgage but does not replace the previous outstanding one. Instead, it functions as a credit card where the homeowner makes cash withdrawals as and when needed.
This withdrawal period or credit line usually lasts 10 years and is called the draw period. During this time, only interest payments on the balance amount withdrawn need to be paid.
Remember that interest rates may be higher in the case of HELOCs. Also, HELOCs typically carry variable interest rates which means both your rate and payments can fluctuate over time.
After the initial draw period, the homeowner either pays the total amount withdrawn as either a lump sum or by installments.
Since HELOCs do not come as a lump sum payment, homeowners have the freedom to borrow cash funds as and when needed. This can be useful, for instance, during home renovations, repairs, improvements, and other similar ongoing projects. Accordingly, the homeowner has the freedom to withdraw subsequent funds as the ongoing project develops.
Comparison between cash-out refinance vs HELOC – What are the key differences between the two?
Making a comparison to decide the best one between cash-out refinance vs HELOC is a major step. Thus, it requires considering various key differentiating factors to understand which home equity method will suit your needs better.
We have here briefly explained each factor’s implication as a comparison between cash-out refinance vs HELOC. But first, let us quickly go through the list of these factors.
- Loan term
- Rate of interest
- Monthly installments or payments
- Immediate cash availability (Yes/No) OR how funds are made available to the homeowner?
- Closing costs (Yes/No)
1. Loan term
In cash-out refinance, the homeowners obtain a new and bigger loan against their home equity. This new loan is primarily used to pay off the old outstanding mortgage. Hence, since this is a new loan altogether, the loan term gets extended.
In HELOC or home equity lines of credit, a second loan is obtained as a separate line of credit. The amount withdrawn is not a lump sum and occasional withdrawals are made depending on the homeowner’s need. Hence, this second loan does not extend the loan payback term. Instead, it adds a second loan repayment term along with the original mortgage payback schedule.
2. Rate of interest
Loans obtained by way of cash-out refinance usually carry fixed interest rates. However, this is optional, and the homeowner can opt for a variable interest rate as well.
Home equity turned funds obtained via HELOC in most cases will typically have adjustable or variable interest rates. This means that the interest rate will fluctuate accordingly with the market.
3. Monthly installments or payments
Monthly installments or payments against loans obtained via cash-out refinance remain fixed and can be predicted.
Loan payment is usually divided between two periods – the draw period and the repayment period. During the draw period, only interest on drawings made is payable. Whereas during the repayment period, payment of principal as well as interest both are paid.
4. Immediate cash availability (Yes/No) and how funds are made available to the homeowner?
Yes. Funds get disbursed to the homeowner immediately at closing. The homeowner receives a lump sum payment of the whole loan amount approved by the lending entity.
Yes. But here, the homeowner does not receive any lump sum payment of the whole loan amount from the lending entity. Instead, he is entitled to a line of credit from which funds can be withdrawn on a need basis.
5. Closing costs (Yes/No)
Yes, provided that the new loan has a fixed interest rate.
Yes, closing costs are applicable.
Deciding factors or Pros and cons of cash-out refinance vs HELOC – A quick recap
Let us now quickly review the deciding factors or simply pros and cons between cash-out refinance vs HELOC.
Pros and cons of cash-out refinance
Pros of cash-out refinance
- Replaces your existing mortgage loan with a new and a better one (especially if lower interest rates are available).
- By replacing the old outstanding mortgage, you still have only one monthly loan payment or installment to pay.
- Funds can be utilized for any purpose.
- Interest expense is allowed as a tax-deductible expense. This means you can deduct interest paid from your taxable income or tax liability.
- Typically carries lower interest rates in comparison to other modes of finance such as personal loans, credit cards, etc.
- Are generally available with a fixed interest rate.
Cons of cash-out refinance
- Obtaining a new loan to replace the old outstanding mortgage may or may not be feasible in your case. This is usually because of unfavorable interest rates and loan terms.
- A new and bigger loan means your monthly installments would now be bigger as well. Similarly, your long-term interest costs may also increase.
- Interest applies to the entire loan amount. This means interest is calculated from the beginning.
- Closing costs are applicable.
- Interest rates may be higher than other regular mortgages.
Pros and cons of HELOC or home equity lines of credit
Pros of HELOC or home equity lines of credit
- Funds borrowed can be used for any purpose.
- No lump sum borrowings are required. Borrow as the need arises. This is highly suitable for ongoing projects where payments are made as the work progresses.
- Interest is payable only on the amount withdrawn and not on the entire loan limit.
- No payment of principal during the drawing period which typically is the first 10 years of the loan term.
- Minimum, as well as sometimes zero closing costs, arise in comparison to cash-out refinance.
- Makes no changes or alterations to the terms of your existing mortgage. This means that it does not affect your existing mortgage terms.
Cons of HELOC or home equity lines of credit
- A HELOC loan carries a variable or adjustable interest rate that fluctuates with the market. This means that your interest payments will also vary and fluctuate.
- While a HELOC loan’s principal amount is not payable during the borrowing period, it may become payable all at once after the borrowing period. This simply means that the borrower may have to return the entire amount borrowed during the borrowing period as a lump sum together with interest due and not as installments or subsequent payments.
- Since a HELOC loan does not replace the old outstanding mortgage, borrowing it simply means adding another liability to your monthly budget. During the borrowing period in HELOC, only monthly interest remains payable on the amount borrowed.
- Interest expense on a HELOC loan is not always allowed as tax-deductible.
When deciding which home equity access method between cash-out refinance vs HELOC suits you better, you need to consider various key factors. These include –
- making a comparison of the amount of equity you hold in your home vs any outstanding mortgage amount,
- the amount of loan you need to borrow,
- duration of the borrowing or for how long do you need to borrow the funds and when do you expect to return it,
- the purpose of borrowing these additional funds, and
- the loan repayment terms that work best for you.
However, if you are not sure about which method works best for you, we recommend seeking professional advice from an expert.
AttorneysFunding.com is not only a veteran-owned mortgage company but also has decades of experience in the mortgage industry. Over the years, our experts have served numerous homeowners like you to decide on the best home equity methods available in their case.
Call us now at (916) 471-2678 or click here to book a free consultation session and discuss your mortgage needs with one of our expert loan officers.