Cash-Out Refinance vs. HELOC: Choosing How to Use Your Equity

A cash-out refinance replaces your current mortgage with a new, larger mortgage and pays you the difference in cash. A home equity line of credit (HELOC) leaves your current mortgage alone and adds a separate, revolving line of credit secured by your home. The choice often depends on how your existing mortgage compares with what is available now, how much you need, and whether you need it all at once.

How a cash-out refinance works

With a cash-out refinance, you take out a new first mortgage for more than you owe. The new loan pays off your old mortgage, and you receive the remaining amount at closing. Afterward, you have one mortgage with one payment, under a new rate and new terms.

Because you are replacing your entire mortgage, a cash-out refinance is a full refinance. That generally means a new application, an appraisal, a Loan Estimate, a Closing Disclosure and closing costs similar in kind to those on a purchase loan. Rates on cash-out refinances are generally somewhat higher than on refinances that do not take cash out, because the lender is lending more against the same home.

A cash-out refinance tends to fit when:

• The terms available on a new mortgage compare well with your existing loan.
• You want a single payment rather than two.
• You need a defined amount of money all at once.
• You also want to change something else about your loan, such as moving from an adjustable rate to a fixed rate.

How a HELOC works

A HELOC is a line of credit secured by your home. If you already have a mortgage, the HELOC becomes a second mortgage behind it. The lender sets a credit limit, and during the draw period you borrow what you need, repay it and borrow again. When the draw period ends, you repay the balance, either over a schedule or, in some plans, as a single balloon payment.

Most HELOCs have variable rates built from an index plus a margin, so your rate and payment can change over time. You pay interest only on what you have drawn, not on the full credit limit.

A HELOC tends to fit when:

• You want to keep your existing first mortgage and its terms in place.
• Your costs will come in stages or are uncertain, such as a phased renovation.
• You want access to funds without borrowing the full amount right away.
• You can handle a payment that may rise or fall.

The biggest difference: what happens to your first mortgage

This is often the deciding factor. A cash-out refinance replaces your whole mortgage balance, not just the extra cash you take out. If your existing mortgage has terms you would not be able to get on a new loan, refinancing means giving those up on the entire balance.

A HELOC leaves your first mortgage untouched. Only the money you draw on the line is subject to the HELOC's rate. That can make a HELOC worth a look when your current mortgage terms are favorable compared with what is available on a new loan.

The reverse is also true. If a new mortgage would compare well with your current one, a cash-out refinance may let you improve the terms on your whole balance while taking cash out at the same time.

Comparing costs

Look at both upfront and long-term costs.

• Upfront costs. A cash-out refinance usually involves closing costs on the full new loan, including lender charges and third-party services such as appraisal and title. A HELOC may have its own costs, such as an appraisal fee, an application fee and other closing costs, and some plans carry ongoing fees such as annual, inactivity or early termination fees.
• Interest over time. With a cash-out refinance, interest is charged on the full new balance. With a HELOC, interest is charged on what you draw. Also consider whether a new mortgage would restart your repayment timeline, which can increase the total interest you pay even if the rate looks attractive.
• Rate risk. A fixed-rate cash-out refinance offers a stable principal and interest payment. A variable-rate HELOC can become more expensive if rates rise.

Ask each lender for written terms and compare the full picture, not just one number. For a refinance, compare Loan Estimates from more than one lender.

Risks to weigh with either option

Both options use your home as collateral, so not making payments could lead to losing your home. Both also reduce your equity, which leaves you with less cushion if home values fall or you need to sell.

Some risks are specific to each:

• Cash-out refinance: Your entire mortgage is reset under new terms, and you pay closing costs on the full loan. If you roll costs into the loan, your balance grows further.
• HELOC: Payments can rise when rates move or when the repayment period starts. Some plans end in a balloon payment. The lender may freeze or reduce your line if your home value drops or your finances weaken. You also carry two separate payments.

If you are using either option to pay off credit cards or other debt, remember that the debt is not gone. It moves onto your home. That can lower the rate you pay, but stretching it over a longer period can cost more overall.

Questions to ask yourself

• How do the terms on my current mortgage compare with what I could get on a new one?
• Do I need a set amount now, or access to money over time?
• Could my budget handle a payment that increases?
• Would I rather have one payment or keep two loans separate?
• How long do I expect to stay in the home?
• Are there alternatives, such as a personal loan or line of credit, that would not put my home at risk?

Two ways the same goal can play out

Picture two homeowners who each want to renovate a kitchen. The first has a mortgage with terms that would be hard to match on a new loan, and the contractor will bill in stages over several months. A HELOC lets that homeowner keep the existing mortgage and draw only as invoices arrive.

The second homeowner has an adjustable-rate mortgage and would like the stability of a fixed rate anyway. For that person, a cash-out refinance can cover the renovation and change the loan type in one step, with one payment afterward. Same project, different fit.

What to have ready before you apply

For either option, lenders typically review your equity, credit history, income and existing debts, and the property itself. Gather recent pay stubs or other income records, tax returns if you are self-employed, your current mortgage statement, homeowners insurance information and a clear idea of how much you need and why. Approval and terms are subject to credit approval and vary by borrower, property and lender.

If you are behind on your mortgage or unsure which path fits, a HUD-approved housing counselor can help you compare your options before you commit.

Frequently asked questions

Next steps

• Cash-Out Refinance
• HELOC

Sources

• CFPB: What other types of loans are similar to a HELOC?
• CFPB: What you should know about home equity lines of credit
• Freddie Mac: Understanding your options for refinancing
• Freddie Mac: Planning to refinance
• CFPB: What is a second mortgage loan or junior lien?