Home equity lines of credit (HELOCs) and cash-out refinances are two methods of tapping into your home equity for cash. They are usually used in the consumer mortgage market to facilitate refinancing property and borrowing against the equity in your home. Cash-out refinances and HELOCs are quite different financial instruments but can be used to accomplish the same purpose. Deciding to use a HELOC or a cash-out refinance involves analyzing the terms of each and making a choice most financially beneficial to you. Knowing the differences can help you make the best decision for you and your family. It may also be a good idea to work with a financial advisor, and SmartAsset’s free tool can match you with advisors that serve your area in just minutes.
What Is a HELOC And How Does It Work?
A home equity line of credit (HELOC) is a financial product that allows you to borrow money using the equity in your home as collateral. It’s different than a home equity loan since a HELOC is disbursed to you over time and as you need it while a home equity loan is disbursed as a lump sum. A HELOC allows you to draw out money up to your credit limit, pay it back and draw it out again.
HELOCs are granted to the creditworthy borrowers that have at least 20% equity or ownership in their homes. They are usually adjustable-rate loans with competitive interest rates. They usually have no closing costs.
Both HELOCs and cash-out refinance loans draw on the equity of your home to provide you with cash. You can use a HELOC to put a down payment on a new house and make the payments on your current mortgage loan until you sell your current house. You can also use the proceeds from a HELOC to pay down high interest credit card debt, take a vacation or renovate your home. Whatever you use it for, remember that you’ve drawn on your home equity to get it. The interest is only tax-deductible if you use the HELOC for home renovations and if you itemize deductions.
How Does a Cash-Out Refinance Work?
If you have built up home equity and have financial needs you need to cover, a cash-out refinance both refinances your house and allows you to use your home like a bank. You can tap into about 80% of your current home’s appraised value to do a cash-out refinance. A cash-out refinance will be larger than your current mortgage since you have to pay off your current mortgage plus you borrow extra for other purposes. Cash-out refinances are similar to HELOCs since both involve tapping into your home equity for your financial needs.
If you are in the market to refinance your house, consider a cash-out refinance carefully before you apply. A rate or term refinance might suit your needs better unless you need the cash from your home equity for something important. Under most circumstances, a cash-out refinance will add to your existing mortgage balance instead of just replacing it with a new loan. That means you’ll pay more in interest expense over the lifetime of the mortgage loan, and you will probably pay interest on interest if you use the cash to pay off other debt.
Difference between a HELOC and a Cash-Out Refinance
Even though a HELOC and a cash-out refinance both tap into your home equity to access cash, they are two very different financial instruments in some ways. A HELOC is a line of credit that has two time periods. The first period is called the draw period and this is when you draw out what you need from your line of credit. You normally only have to pay interest on the amount you have drawn out during this period. It is around 10 years in length. The second period is the repayment period, and it is usually the next 10 years of the line of credit.
A cash-out refinance is a brand-new mortgage loan on your house. It is distributed as a lump sum, not a line of credit. Your old mortgage is paid off by the new loan and the rest of the new loan is distributed to you by a check at closing. It is usually a lump sum although if you are using the money for credit card debt, some lenders will give you checks made out to the credit card companies.
Cash-Out Refinance and HELOC Specifics
When you receive a cash-out refinance mortgage loan, since it is distributed to you in a lump sum, you start paying interest on the entire mortgage loan immediately. With a HELOC, you only pay interest on the amount you’ve drawn from your line of credit during the draw period. This could save you thousands of dollars in interest charges over the life of the loan compared to a cash-out refinance.
The interest rates on a cash-out refinance tend to be slightly lower than on HELOCs which partially offset the benefits of a HELOC when it comes to interest charges. Cash-out refinances usually have fixed interest rates over the life of the loan while HELOCs have adjustable rates. This makes the cash-out refinance preferable in a rising interest rate environment. You usually get a 20-year term with a HELOC. Cash-out refinances may have a longer 30-year term or a shorter 15-year term.
Lenders normally only allow borrowing up to 80% of the appraised value of your house for a cash-out refinance. For a HELOC, it’s often possible to borrow up to 90%. With both financial instruments, your home is the collateral for the loan. Your interest payments are usually tax-deductible on a cash-out refinance and are only deductible in certain situations on a HELOC.
Whether you choose to use a HELOC or a cash-out refinance to tap into your home equity depends on your situation and your qualifications for each. It also depends on the terms of each type of financing. At the end of the day, it’s important to remember that only you can decide which makes the most sense for you.
Home Buying Tips
- Consider working with a financial advisor as you make decisions about handling real estate debt. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- The world of real estate is complicated, so it’s important to be informed before diving in. SmartAsset has you covered with a number of free online resources. If you’re looking to get educated about the state of mortgage rate environment, consider using SmartAsset’s mortgage rates table.
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