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HELOC Vs. Cash-Out Refi: Which One Should You Get?
By Jessica Walrack MONEY RESEARCH COLLECTIVE
When you pay down your mortgage, see your house appreciate rapidly in a hot housing market, or boost its value through home improvements, you build home equity. That’s an asset you can borrow against. But which type of financing is best? Two popular options are a home equity line of credit (HELOC) and a cash-out refinance loan (cash-out refi). While both can give you access to a large lump sum, there are a few key differences you should know. Here’s a closer look at each option and when it may be a good idea.
Table of Contents
- What is a HELOC?
- What is a cash-out refinance?
- Which is better: a HELOC or a cash-out refinance?
- HELOC vs. Cash-Out Refi FAQs
- Summary
What is a HELOC?
A HELOC is a revolving credit line backed by your home equity. For example, suppose a recent appraisal sets your home’s value at $400,000 and you owe $225,000 on your mortgage. In that case, you’ll have $175,000 of equity. In most cases, lenders will only let you borrow a percentage of that — often 75 to 85%. So if you can borrow up to 80% of your equity, you’ll be eligible for a HELOC of up to $140,000.
What happens next? Once you get approved and your HELOC is finalized, the draw period begins. That means you have access to the credit line for a set period, typically from five to 10 years. You’ll be charged interest on any amount you withdraw during that time based on the annual percentage rate (APR) your lender assigns you. Most lenders offer variable APRs for HELOCs which are attached to an index like the Prime Rate, so your interest rate may fluctuate over time.
When the draw period ends, the repayment period begins. Your lender may require a balloon payment for the outstanding balance or might convert it into a term loan of 15 to 20 years. If you default on your payments, your lender will typically have a second position lien on your home and can initiate a foreclosure. But as long as you make your payments on time, you’ll pay off the balance eventually – and in the meantime, you’ll be boosting your credit history.
Pros and cons of home equity lines of credit
- Large credit line available
- Lower fees than cash-out refi
- Only pay for what you use
- Interest-only payments during the draw period
- Variable interest rates can fluctuate
- Secured by your home
- Often means two monthly mortgage payments
- Less predictable repayment costs
- Higher APRs than cash-out refi
- Can't borrow 100% of equity
Requirements for a HELOC
HELOC requirements will vary by lender but commonly include:
- Sufficient home equity: Lenders require you to have a certain amount of equity to qualify. For example, Rocket Mortgage requires at least 15-20% equity.
- Good credit: Lenders look at your credit and often want to see a score of at least 680 to 700.
- Verifiable income: You’ll need to show proof that you have a reliable source of income that enables you to make the payments (e.g. pay stubs, W2s, or tax returns).
- Consistent payment history: Lenders check your credit report to view your payment history. Derogatory marks can hurt your chances of approval.
- Low debt-to-income (DTI) ratio: Lenders often require a DTI ratio of 43% or less.
What is a cash-out refinance?
A cash-out refi also allows you to tap into your home’s equity. However, instead of a credit line, you receive a term loan large enough to pay off your existing mortgage and have cash left over.
For example, let’s say your home is appraised for $500,000 and you owe $150,000. If your lender says you can borrow up to 80% of your home’s equity, you could take out a cash-out refi loan up to $400,000. After paying off your outstanding mortgage balance, you’ll have $250,000 left over to use as you please.
Since cash-out refis replace your primary mortgage, they take the first lien position. So if you end up defaulting, they are first to benefit from the sale of your home. As a result, they present less risk to the lender than a HELOC and often come with lower interest rates.
Additionally, lenders typically offer fixed interest rates in addition to adjustable rates. The fixed rates guarantee you a fixed payment over a set amount of time, making it easy to plan your budget far into the future. However, cash-out refis do require you to pay closing costs which means a larger upfront cost.
Pros and cons of cash-out refinance
- Borrow against equity through a term loan
- One single monthly mortgage payment
- Fixed-rate APRs available
- Lower interest rates
- Predictable payments
- Closing costs
- Interest from day one on the entire amount
- Extends original mortgage loan term
- Can't borrow 100% of equity
Requirements for a cash-out refinance
The requirements for a cash-out refi will also vary by lender. However, here are a few common requirements:
- Sufficient equity: You’ll need to have a sufficient amount of equity in your home to meet the lender’s loan-to-value ratio requirements.
- Good credit score: Mortgage lenders check your credit and often require a minimum score. For example, Discover requires a score of at least 620.
- Consistent payment history: You’ll need to have a good track record of making on-time payments. If you have any negative marks, lenders may consider how long ago they were and if you have positive marks to balance them out.
- Verifiable income: Lenders will look to see if you have a reliable and verifiable source of income.
- Qualifying DTI ratio: A maximum DTI is often set around 43%.
Which is better: A HELOC or a cash-out refinance?
Now that you know the basics of HELOCs and cash-out refinance loans, which is best for your situation? Here’s a closer look at when one may be better than the other.
When is a cash-out refinancing a good idea?
A cash-out refinance can be a good idea when you need a lump sum for a large purchase — like a down payment on a second home. When you get the full amount and use it promptly, you won’t miss out on any interest savings a HELOC could offer through the gradual use of the funds. Further, the option for a fixed APR can enable you to enjoy predictable, fixed payments that stay the same over the life of the loan.
When is a home equity line of credit a good idea?
A HELOC can be a good idea when you need a large sum but plan to use it in stages. Additionally, it can come in handy if you aren’t sure exactly how much money you’ll need.
For example, if you are planning a home remodel or renovation project, you usually pay for it in phases. Withdrawing funds as you need them can delay the accumulation of interest charges.
Further, you may run into some issues that result in extra expenses. You can take out a credit line larger than your budget, and only use it if you need it.
HELOCs also don’t have closing costs so will be more affordable upfront. However, the higher adjustable APRs and shorter repayment terms can mean more expensive monthly payments once full repayments begin.
HELOC vs. cash-out refi FAQs
Which is easier to qualify for, a HELOC or cash-out refinance?
A cash-out refinance will typically be easier to qualify for because the lender gets the first lien position if your home goes into foreclosure. HELOCs are usually second mortgages so the lenders take the second lien position. As a result, HELOC lenders usually face more risk which is often compensated for through higher APRs and stricter eligibility requirements.
What's better: a HELOC or a cash-out refinance?
The best option for you will depend on whether you need the money all at once or in stages. A HELOC can be better for accessing funds over time because you're not charged interest until you use the funds. However, you'll have to weigh all the pros and cons of both (see above) to decide which is better for your situation.
Can you pay off a HELOC with a cash-out refinance?
Some lenders let you use a cash-out refinance loan to pay off your HELOC, pay off your first mortgage, and get additional funds. Qualifying will depend on your creditworthiness and how much equity you have available.
Is it possible to get a HELOC if your credit is bad?
Credit requirements vary by lender but most will want to see at least a "good" FICO score. According to Experian, most HELOC lenders require a score of at least 680. That said, HELOCs can have more flexible credit requirements than unsecured options like personal loans or credit cards because they are backed by an asset.
What is the main difference between a HELOC and a cash-out refinance?
A HELOC is a revolving credit line while a cash-out refinance is a term loan that replaces your current mortgage.
Summary of our guide to HELOC Vs. cash-out refi
Both HELOCs and cash-out refinance loans can help you access the home equity you’ve acquired. When deciding between the two, be sure to compare the pros and cons of both options. Beyond that, run the numbers on both to estimate your monthly payment and overall costs.
The HELOC will likely be cheaper upfront. Even though the cost may be higher in the long run, the interest-only payments for five to 10 years could make it worth it for you. On the other hand, you may find that paying the closing costs upfront for the cash-out refi is worth it thanks to the low APR and predictable payment schedule. Only you can decide which makes the most sense for you. A good next step is getting quotes from lenders to see what kind of rates you can expect.
Ready to start shopping around? Check out six of the best home equity loans on the market!
