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Cash-out refinance vs. HELOC: Which should you choose?

Yahoo Personal Finance· Getty Images
Updated 9 min read

If you need to pay off debt, remodel your residence, or cover another large expense, consider tapping into your home equity. Two popular tools for doing so are a cash-out refinance and a home equity line of credit (HELOC).

We compared cash-out refinancing and HELOCs to help you decide which is the better fit. Keep reading to find out which home equity product may be right for you.

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Your home equity is how much your house is worth minus your remaining mortgage balance. For example, if your property gets appraised at $400,000 and you still owe $200,000 on your mortgage, you have $200,000 worth of equity — or 50% equity.

Home equity products generally require you to have at least 10% to 20% home equity to qualify. Following the above example, if a lender asks you to have 20% equity to get a HELOC or cash-out refinance, your mortgage loan balance must be $320,000 or less.

Lenders may also use the term loan-to-value (LTV) ratio. Your LTV ratio is another way to describe how much you owe on your house compared to its worth and is the inverse of your home equity percentage. For example, if you have 20% home equity, your LTV ratio is 80%, which signifies that you still owe 80% of your residence's appraised value.

With a cash-out refinance, you take out a new mortgage that’s large enough to both pay off your existing mortgage and put a lump sum into your pocket. Then, you can use the extra funds any way you see fit.

Getting a cash-out refi will feel similar to securing your original mortgage. You’ll need to:

  • Get a home appraisal to determine how much you can borrow. Generally, you can borrow up to 80% of your residence’s value. However, if you’re a VA home loan holder, you may be able to borrow up to 100%.

  • Pay closing costs to finalize your new loan. Your costs will be a percentage of your new mortgage amount and may include an origination fee, attorney fee, or other expenses.

  • Meet lender-specific eligibility requirements. While each mortgage lender will have its own criteria, you'll typically need at least a fair credit score and a debt-to-income ratio (DTI) — the amount you pay toward debts each month compared to the amount you earn — below 43%.

Once you’ve closed on your new mortgage, you’ll start making full principal and interest payments almost immediately. Most lenders offer 15-year and 30-year terms, and some may have even more term lengths to choose from.

Your cash-out refi could have a fixed or adjustable interest rate. With a fixed interest rate, your monthly mortgage payments will be stable over the life of the debt. However, with an adjustable interest rate, your monthly payments may fluctuate.

  • You’ll only have one mortgage to keep track of and repay.

  • Your monthly payment will stay consistent (with a fixed-rate loan).

  • You can take quick action toward your goals after receiving your lump sum.

  • Your home loan may be more expensive since mortgage rates have increased in recent years.

  • You’ll have to pay closing costs.

  • You could lose your home if you default on your new mortgage.

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With a home equity line of credit (HELOC), you take out a second mortgage you must manage and repay alongside your existing mortgage loan. Instead of receiving a lump sum upon closing, you’ll gain access to a line of credit you can use for any purpose. You may be able to borrow up to 80% or even 90% of your property’s value, depending on the lender.

As a second mortgage, a HELOC presents a greater risk to your lender because your primary mortgage will get repaid first should your home go into foreclosure. That increased risk translates into stricter qualification requirements than a cash-out refinance.

For example, you’ll generally need a higher credit score to qualify for a HELOC. Plus, you’ll likely pay a higher interest rate than you would if you refinanced your initial mortgage.

Your HELOC will be split into two phases: the draw period and repayment period. During the draw period, which usually lasts up to 10 years, you can spend up to your approved credit limit. You can replenish your available funds by paying down the principal balance as you would with a credit card. Many lenders only require you to make interest payments during this phase, though. Your HELOC will likely come with a variable interest rate, but some lenders do offer fixed-rate HELOCs.

Once you enter the repayment period, you can no longer access your line of credit. You must then make principal and interest payments for the remainder of the loan term, generally up to 20 years.

  • Your new interest rate will only apply to the money you take out with your second mortgage — you’ll keep your old rate on your original mortgage balance. This is a pro if rates have increased since you bought your home.

  • Your line of credit gives you flexible access to your money. You’ll only need to repay what you actually use.

  • You’ll probably pay few (or maybe even no) closing costs to get your second mortgage.

  • You’ll have two housing debts to repay: your existing mortgage and the HELOC.

  • Your monthly payment could fluctuate due to the loan’s variable interest rate.

  • You may have difficulty transitioning from the interest-only payments of the draw phase to the full payments of the repayment phase.

  • You could lose your home to foreclosure if you don’t repay the debt as agreed.

Learn more: HELOC vs. home equity loan — Tapping your equity when rates are high

While both financial products can help you borrow against your home’s equity, one may be a better fit for your situation than the other. You should consider several factors, including the interest rate, repayment term, closing costs, the purpose of the loan, and how much you need to borrow.

A cash-out refinance may be appropriate if you want to use the money to pay off a significant amount of more expensive debt. “Credit card interest rates are 20%+, and that is really taking up people's income,” said Kadyn Nannini, mortgage loan officer at One Real Mortgage, via email.

“A refinance, even at 7% but amortized over 30 years, can really reduce the overall monthly debt load of a household and create some peace of mind, which I think has a non-tangible value to it that needs to be considered. I have seen people refinance to a 7% rate and pay off all other debt and be so happy because now their only debt is an appreciating asset,” Nannini continued.

That being said, weigh the pros and cons of using a secured loan (which is attached to collateral, like a house) to pay off a non-secured loan. Although there are consequences for not repaying your credit card, there’s a much more significant consequence for not paying back your mortgage — namely, you could lose your house in foreclosure.

A cash-out refi may also be your best bet if you want a predictable monthly payment over the life of the debt.

“Some people do not like interest-only payments, and that is what a HELOC is to start for the first 10 years,” said Nannini.

“[Many borrowers] like to set their payment and forget it. So in a situation where someone needs to take some money out of their house, and their first mortgage is relatively low, like less than $200,000, then a cash-out refinance might make sense so they can set their fixed payment and not have to worry about it,” Nannini explained.

Dig deeper: Cash-out refinance vs. home equity loan

A HELOC could be better if your current mortgage has a low interest rate and you only need to borrow a relatively small amount.

“Since most people have low rates below 4%, it might not make sense to completely refinance all of their housing debt when their debt is so cheap. A HELOC is the perfect solution. They can take the [required sum] out at a higher rate, keep their first mortgage payment low, and then figure out what they need to pay to work down the [new debt],” said Nannini.

In addition, you may be able to qualify for a HELOC with less equity in your home, depending on which lender you use. “HELOCs allow you to have a higher LTV (loan-to-value) ratio on your home versus a cash-out refinance. Between your first mortgage and a HELOC, you can use up to 90% of your home's value, whereas a cash-out refinance only allows you to go up to 80%,” said Nannini.

Lastly, a HELOC can be appropriate if you’re unsure how much you want to borrow. You only have to repay the amount you borrow, so you’re off the hook if you don’t end up using the full amount available.

Learn more: 4 types of home renovation loans and how to choose

There are a few differences between a cash-out refinance and a HELOC. With a cash-out refinance, you take out a new mortgage to replace your existing home loan, receive your money as a lump sum, and begin making full payments shortly after closing. With a HELOC, you take out a second mortgage, can borrow money up to your credit limit for the duration of your draw period, and often only need to pay the interest on what you borrow until the repayment phase begins (generally after 10 years).

A cash-out refinance may be better than a HELOC in select circumstances. For instance, a cash-out refinance makes sense if mortgage interest rates have dropped since you took out your original home loan. A cash-out refinance could also make sense if you want to limit your housing debt to one loan or borrow a large sum.

No, you don’t have to pay taxes on the money you receive on a cash-out refinance. Since the funds are loaned to you, the cash isn’t considered taxable income. However, if you use the money to improve the home that secures the debt, you may be able to write off the mortgage interest you pay on your tax return.

This article was edited by Laura Grace Tarpley