Cash-Out Refinance vs. HELOC and Home Equity Loans: Which Is Better?

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When you need access to funds, your home may be your best asset. As homeowners pay down their mortgage loans, they build up ownership in their property, and, with each payment, accumulate value in an asset that can potentially be borrowed against in the future. Your home equity is the difference between the balance you owe on your mortgage and the value of your property. You can convert that equity to cash and use it to pay down debt, finance home improvements or pay for life expenses like college tuition.

There are several ways to leverage your home equity: a cash-out refinancing, a home equity line of credit, or HELOC, and a home equity loan. Depending on your needs, each option features advantages and disadvantages, so it is important to understand all your options.

When considering home loans, consumers should compare all the available options, and consider consulting with a mortgage adviser and a tax professional.

When Hillary Legrain, vice president for Bethesda, Md.-based First Savings Mortgage, works with clients, she takes a detailed inventory of a homeowner’s priorities, including their monthly payment limits, their appetite for risk if interest rates shift and how much money they want to access. She also details their home equity position, income level, credit score and whether they are comfortable paying for closing costs, which could run several thousand dollars. Armed with this information, Legrain says she can recommend the best loan products.

A cash-out refinance pays off your current mortgage and replaces it with a new mortgage and uses your home equity for cash for other purposes. Your new loan includes the remaining balance on your mortgage and the cash, plus interest.

A home equity loan, also known as a second mortgage, provides borrowers with a lump-sum loan and features a fixed interest rate. Your home equity is the collateral for your loan.

A home equity line of credit, also known as a HELOC, allows a borrower to draw money multiple times from an available maximum amount as needed. Interest rates are typically variable. You’ll usually get special checks or a credit card from your lender to access the funds.

Key differences between a home equity loan, home equity line of credit and cash-out refinance

Cash-Out Refinance HELOC Home Equity Loan
Pros

By paying off your existing mortgage and taking on a new loan, you may be able to take advantage of lower rates, shorter terms or lower payments.

The new loan functions just like your first mortgage, with set monthly payments and an amortization schedule.

Current interest rates may be lower than your previous loan’s.

Your interest may be tax-deductible.

Rather than borrowing a lump sum and paying back the entire loan plus interest, a HELOC allows you to take funds you need and only pay off the borrowed funds and applicable interest.

Most HELOCs only require minimum monthly payments for a period of time, often 10 years, before you enter the repayment phase.

Under the new tax law, interest may be tax-deductible if used for home improvements.

A second mortgage provides a one-time cash distribution to pay down debt, make home improvements or fund large expenses, such as college tuition.

Fixed interest rates allow you to clearly understand your monthly payment and terms.

Typically no upfront costs or fees.

Under the new tax law, interest may be tax-deductible if used for home improvements.

Cons

Because you’re initiating a new mortgage, there are closing fees similar to your original loan, often several thousand dollars.

You have to pay down the new loan over the term, plus interest.

A variable rate could cause monthly payments to fluctuate.

Cash-out refinance is usually limited to up to 80% to 90% of home’s value, possibly up to 95%.

Because you’re going through the mortgage application process again, it can take longer to receive funds than with a home equity loan.

Variable interest rates are unpredictable and could cause your monthly payments to increase.

The draw period could be limited to the first 10 years, after which you can’t access any more funds.

During repayment, monthly payments increase as you pay down principal as well as interest.

If you don’t make all your payments by the end of the term, you may have to make a single lump- sum payment.

Because this is a second lien on your property, interest rates tend to be higher than your first mortgage might have been.

If you can’t repay, your lender could foreclose on your property.

A second mortgage may have upfront fees and charges.

Loan terms

When choosing among any home loans, borrowers should consider their timeline for repayment, mortgage advisers say. Because a cash-out refinancing replaces your original mortgage with a new loan, borrowers are subject to similar loan terms, typically 15, 20 or 30 years, and monthly payments could be higher or lower than your original mortgage, depending on the interest rate.

These loan terms are important considerations and clients often have different priorities, said Peter Grabel, managing director of the Stamford, Conn.-based Luxury Mortgage Corp. Some homeowners prefer fixed interest rates and set monthly payments, which could come from a cash-out refinance or home equity loan. “If it is fixed and steady, you don’t have to worry about rates going up,” he said. As a HELOC allows borrowers to draw for a period of time with minimum payments, and then have an additional 10 to 20 years for the repayment period, Grabel says planning is required. “A line of credit can be risky if you don’t have a long-term plan to pay it back,” he said.

Cash-Out Refinance HELOC Home Equity Loan
Loan Term

Like an original mortgage, terms tend to be 10, 15, or up to 30 years. When your loan term is over, your new mortgage should be paid off.

Typically, funds can be accessed for 10 to 20 years with minimum payments. Then, the repayment period usually runs another 10 or 20 years. Minimum term could be five years.

As a second mortgage, a home equity loan can run between five to 30 years.

Borrowing limits

Borrowing limits will vary by the type of loan and your lender, and are typically based on your home equity and your loan-to-value (LTV) ratio, which is the amount of all home loans compared with the value of the property securing the loan, as well as credit score, income and debt-to-income (DTI) ratio, which typically cannot exceed 43%. “Most lenders will look at credit score, available equity and lendable equity,” said Jon Giles, senior vice president and head of home equity lending for TD Bank.

Cash-Out Refinance HELOC Home Equity Loan
Borrowing limits

Typically, homeowners can “cash out” up to 80% to 90% of a home’s value, depending on the lender.

Up to 95% of your home equity, depending on your LTV ratio, income and credit score.

Limits based on the equity you have in your home. Some lenders, such as Discover, offer dollar values from $35,000 to $150,000

Credit requirements

Your credit score plays an important role in your home loan options. Homeowners with higher credit scores may enjoy lower rates both for fixed-rate lows and introductory periods on variable loans. Most lenders will require borrowers to have a credit score of 660 or better, according to Grabel. “It is very difficult to get home loans with bad credit. These loans are credit dependent because the lender is in the second lien position,” he said. In the event of a foreclosure, the lender on a secondary mortgage only gets to collect after the primary mortgage lender receives their proceeds from a sale.

Many lenders base their offers on credit scores of 700 or higher, and small differences in your credit score can end up affecting your loan terms, Legrain said. “With a cash-out refinance, the rate will become higher as you move down every 20 points in the credit score,” she said.

With a HELOC, consumers with lower credit scores may face significantly higher interest rates. For instance, FICO estimates a borrower with a 620 score might pay 12.6% for a HELOC, while someone with a 740 score could borrow at a 6.64% interest rate.

Cash-Out Refinance HELOC Home Equity Loan
Credit requirements

Minimum credit score of 660 or higher, depending on lenders.
You may qualify for an FHA cash-out refinance if you have a lower credit score.

Typically 680 or higher, depending on the lender. Lower scores depend on lender. Interest rates increase with lower scores.

Most lenders require a 680 or higher, although if you have significant equity in your home, you may have more options.

Equity requirements

The amount of equity you have built up in your home and your LTV ratio are the key factors when looking to borrow against your home equity, mortgage advisers said. “Most lenders will loan between 80 and 90% against the value of property, then subtract first mortgage and that will leave the borrowable amount,” Giles said.

Cash-Out Refinance HELOC Home Equity Loan
Equity requirements

Cash-out amount tied to your LTV, the percentage of your home’s value that you still owe.

Most lenders look for an 80% LTV or higher.

Your LTV ratio to determine how much you can borrow.

Most lenders look for an 80% LTV or higher.

Lenders also look for a DTI ratio below 43% of your monthly pretax income.

Loan amount will depend on the amount of equity you have in your home.

Lenders also look for a DTI ratio below 43% of your monthly pretax income.

Interest rates

One of the most important differences among a cash-out refinance, HELOC and a home equity loan is whether the interest rate is fixed or variable. Sometimes, it can be a combination of the two, with a fixed rate for an introductory period, then variable rates kick in. Some banks, such as Bank of America, offer rate discounts for preferred clients, for making initial draws or for enrolling in auto pay, while some credit unions require borrowers to be members and pay annual fees.

Cash-Out Refinance HELOC Home Equity Loan
Interest Rates

Because a cash-out refinance results in a new primary mortgage, rates will reflect current market offers and will depend on similar factors as your original mortgage, including your LTV ratio, income and credit score.

If you have an interest rate that is higher than current rates, a fixed rate cash-out refinance could result in a lower interest rate.

Adjustable cash-out refinance loans may start with a lower fixed rate for a period of time and then adjust periodically.

As low as 4.25% fixed.

Variable rates are tied to the highest prime lending rate and then may have an added margin. Some banks offer fixed introductory rates, which could be lower for a set period of time before the rates become variable.

Some banks offer discounts for clients with other accounts, while others offer some rate guarantees. Wells Fargo says its interest will not exceed more than 2% annually, based on when your line was issued, and never be more than 7% higher than your opening rate.

As low as 4.75% introductory and then variable rates apply.

Fixed rates are set for the term. For qualified borrowers, US Bank recently offered 5.49% APR for a 10-year loan and 5.74% for a 15-year.

Rates tend to be higher than a primary mortgage because a second mortgage puts a lender in a second- lien position in the event of foreclosure.

As low as 5.75% to 6.25% fixed.

Risk level

The risk level for each of these products will vary greatly by homeowner and is dependent on your financial particulars. In general, Grabel says any loan with a variable interest rate carries the most risk, as rates have been slowly rising and it is impossible to predict where they’ll head in coming years.

Cash-Out Refinance HELOC Home Equity Loan
Risk level

Because a cash-out refinance replaces your original mortgage with a new loan, there will be closing costs and other associated fees, which can total several thousand dollars, depending on the dollar amount of the new mortgage.

A variable-rate loan could result in higher monthly payments if rates go up.

Because the interest rate is often variable, if rates increase, HELOC customers can see their rates climb and monthly payments increase.

Once the repayment period kicks in, monthly payments can increase considerably.

HELOC customers can pay down their loan early, but may face prepayment penalties.

If a homeowner defaults on his or her home equity loan payments, they risk a lender starting foreclosure proceedings.

Hypothetical scenario

When comparing loan products, it helps to sketch out the possible scenarios. Consider this situation: You are interested in tapping into your home equity and considering a cash-out refinance, a HELOC or a home equity loan. The home is worth $300,000 and you owe $100,000 on the primary mortgage. That leaves $200,000 in home equity. You want to access $100,000 of that value to use toward paying down other debt, home improvements and college tuition. Your credit score is strong, at 740 or higher.

Cash-out refinance:

Since you want to pull out $100,000 of your equity but you still owe $100,000 on your first mortgage, your new loan will total $200,000. At closing, your old mortgage will be paid off and you’ll receive the $100,000 in funds (although it could be slightly less because of closing costs). Your new mortgage will total $200,000 and you will make monthly payments for the period of the loan, typically 10, 15, 20 or 30 years, plus interest. Depending on the size of your mortgage, you’ll likely pay several thousand dollars in closing costs and fees, much like you did when you applied for your first mortgage.

In this scenario, a cash-out refinance for a new 30-year loan with a fixed 4.25% interest rate would result in about $1,350 per month in payments over the life of the loan. LendingTree, the parent company of Student Loan Hero, offers an easy-to-use cash-out refinance calculator to help calculate your options.

HELOC:

You’d like to access $100,000 of your equity but you don’t need the money all at once, so you apply for a line of credit and your home equity serves as the collateral. A HELOC typically does not have any upfront or closing costs. A HELOC offers homeowners cash when they need it, rather than a lump-sum amount. Most lenders will provide the borrower with a credit or debit card, checks and online banking to access their HELOC funds. As you draw money, you pay back the principal and interest on that amount. Typically, you can access money for 10 years while making minimum payments. Then, you have an additional 10 to 20 years of repayment, during which you pay back the remaining balance but can no longer draw on the line.

While the HELOC will give you flexibility to take money as you need it and pay it down, your actual repayment amounts can vary. That’s because most HELOCs come with a fixed introductory interest rate but then convert to a variable interest rate, which is tied to the prime rate. If rates go up, it could cost you more to repay the loan. A current HELOC from US Bank, for example, offers a 5.49% introductory APR rate for qualified borrowers, but the bank says rates can range from 5.2% to 8.6%.

At current rates, a variable-rate HELOC with access to $100,000 at a 5.44% APR would cost a homeowner about $450 per month, US Bank estimated.

Home equity loan:

You’d like to use your home equity to receive $100,000 in cash and opt for a second mortgage to access those funds. This option could make sense if you want a fixed interest rate and predictable monthly payments. “Home equity loans are increasing in popularity to lock in rates,” Giles said. You can select a term for repayment up to 30 years. Also, because most home equity loans do not require application fees or closing costs, you won’t face additional fees.

However, because a home equity loan is a second mortgage and riskier for the lender, interest rates tend to be higher than first mortgages.

At current rates, a 30-year fixed-rate home equity loan for $100,000 would carry 6.35% APR and $634-per-month payment, while a 10-year loan would have a 5.34% APR and about a $1,000 monthly payment, per US Bank estimates.

Conclusion

When it comes to assessing the risk profile of each loan, TD Bank’s Giles says homeowners need to be honest about both their finances and their personal habits.

“Some people need the predictability of a fixed interest rate and set monthly payment,” he said, making a cash-out refinance or home equity loan a better option. “If you have the discipline to make regular payments and maybe even pay down principal, a line could make a lot of sense,” Giles added.

To assess the best option for you, mortgage advisers recommend making a spreadsheet that compares the three products, or meeting with a loan specialist to walk through scenarios. The interest on a new home equity loan, HELOC or cash-out refinance loan may still be deductible for you, so also speak to a tax professional.

And remember to shop around, as different lenders will feature a variety of offers, interest rates and terms. “It is important to know what you need and what will work for you,” Giles said.

This article contains links to LendingTree, our parent company.

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