As you pay down your mortgage and your home rises in value, you build up a powerful financial tool: home equity. Borrowing against this equity gives you access to cash you can use to fix up your home, consolidate debt, or meet an unexpected expense.
Two of the most common ways to use your home equity are through a home equity line of credit (HELOC) or cash-out refinance. In this article, we’ll go over the pros and cons of each — helping you decide which might be right for your situation.
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What is a HELOC?
A home equity line of credit, commonly known as a HELOC, is a way to borrow against your home equity that works much like a credit card. It’s an additional loan — sometimes called a second mortgage — which you’ll need to pay on top of your regular home loan.
Your lender will give you a spending limit based on the amount of equity in your home and your credit score. Then, you can spend from this account as many times as you like over a period of years. Most HELOC lenders will issue you a credit card or paper checks you can use to access the funds.
During this “draw period,” you’re often only required to pay interest on what you actually spend. It’s a revolving line of credit, so if you choose to pay back some of the principal, you’ll build your available credit back up.
When the draw period ends, you’ll either renew your HELOC or enter a “repayment period” — when you’ll repay everything you borrowed plus interest.
Tip:
HELOCs typically have variable interest rates that can change over time, depending on market conditions. If you have a good credit score, you can more easily qualify for a low rate on a HELOC that may appeal to you as mortgage rates rise.
What is a cash-out refinance?
A cash-out refinance, sometimes shortened to “cash-out refi,” is a significantly different way to borrow from the equity in your home. With a cash-out refinance, you take out a new mortgage that pays off and replaces your current one. This new mortgage is for a larger amount than you currently owe, with the difference coming to you as cash. The amount you can take out will depend on how much equity you have in your home.
After a cash-out refinance, you’re left with a single loan that you’ll pay back just like any other mortgage. This new loan will have a new loan term and interest rate, likely different from your current mortgage. If interest rates have fallen since you originally bought your home, a cash-out refinance may be more attractive.
Learn More: Reasons for a Cash-Out Refinance: How to Use Your Home Equity
How are HELOCs and cash-out refinances similar?
Both HELOCs and cash-out refinances are ways to borrow money from your home equity. There are many similarities in how they’re structured and what you’ll need to qualify. For example, both HELOCs and cash-out refinances:
- Are secured by your property: This means you risk losing your home to foreclosure if you fail to make your payments.
- Require you to have a significant amount of equity in your home: In most cases, you must be left with at least 20% equity in your home after borrowing money.
- Have credit score requirements: Many lenders require a minimum credit score to qualify for a HELOC. Scores below 725 are typically considered “higher risk.” For a cash-out refinance, you’ll need to meet the credit score requirement for the mortgage you choose. This is usually 620 for many types of loans.
- Need a home appraisal: Your lender will likely ask you to order a home appraisal to assess the value of your home and determine exactly how much equity you have. In most cases, you’ll need to pay for this appraisal.
How are HELOCs and cash-out refinances different?
With that said, HELOCs and cash-out refinances operate in very different ways. They also have significant differences in terms. These include differences in:
- Interest rates: HELOCs typically have variable rates that can change over time. Your payments may rise if interest rates go up. With a cash-out refinance, you’ll typically take out a new fixed-rate mortgage. Your monthly payment will stay the same as long as you have the loan.
- How your loan is paid out: With cash-out refinancing, you receive your money in a lump sum that you can then use as you see fit. A HELOC is different in that you have a credit limit you can withdraw from in different amounts over time.
- How you access your money: Once you’ve completed a cash-out refinance, you simply have the cash in your bank account. With a HELOC, you’ll use the debit card, credit card, or special checks attached to your account.
- Structure: A HELOC is a second loan you have on top of your mortgage. With a cash-out refinance, you’re left with a single loan.
- Closing costs: With cash-out refinancing, you’ll pay all of the standard closing costs that come with taking out a mortgage. HELOCs generally have much smaller closing costs — and some lenders waive them entirely.
Should I get a HELOC or cash-out refinance?
The right choice for you depends on your financial needs and the broader interest rate environment. When interest rates are low, cash-out refinances can be a good option. That’s because you may be able to lower your interest rate on your mortgage while also gaining access to cash you can use however you desire.
As interest rates rise, you might find that a home equity line of credit becomes more attractive. You may be hesitant to refinance your mortgage and saddle yourself with a higher interest rate that you’ll potentially pay for decades. In this case, it might be a good idea to take out a HELOC and leave your current low-rate mortgage alone.
However, your credit history also plays a major role. It’s generally harder to qualify for a HELOC than it is for a cash-out refinance. If you have fair or poor credit, you may not have the option to take out a HELOC at all, or your rate may be higher than you’re willing to pay. In this case, a cash-out refinance may be a better option.
If your financial situation has improved significantly since you first took out your mortgage, you may also be able to qualify for a lower rate through a cash-out refinance even if rates in the broader market have risen.
A loan officer can help you run the numbers and give you information on what you’ll likely pay by using a cash-out refinance and a HELOC.
Keep Reading: Using a Home Equity Loan or HELOC to Pay Off Your Mortgage
