Should I get a cash out refinance or HELOC?
A cash out refinance or HELOC (home equity line of credit) lets homeowners turn some of their “equity” into cash. But when you’re choosing between them, you’ll need to consider the specifics of your personal finances to determine which type of loan is right for you.
What’s the difference between a second mortgage and a refinance?
HELOCs, home equity loans and cash out refinances all let you get your hands on cash that’s currently tied up in your home.
HELOCs and home equity loans are second mortgages. In other words, you borrow and repay them in parallel with your original mortgage. And that means two monthly mortgage payments.
However, a refinance involves swapping your current mortgage for a completely new one.
Read on to discover the detailed differences in costs and characteristics that can make any of them the best in different circumstances.Click here for today's refinance mortgage rates.
Different options for tapping home equity
What is a cash out refinance?
You get a whole new mortgage. But you borrow more than you’d need just to replace your existing one and you receive a check for the difference.
What is a HELOC?
It’s a second mortgage that complements — rather than replaces — your first mortgage. You get a line of credit, similar to the one you get with a credit card. So you can borrow, repay, and borrow again up to your credit limit. And you pay interest only on your outstanding balance.
What is a home equity loan?
This, too, is a second mortgage. But, instead of getting a line of credit, you receive a lump sum, which you pay down in equal installments.
What’s the difference between a HELOC and a home equity loan (HEL)?
We just covered the main differences. But there are others:
- HELOCs usually have variable interest rates while HELs usually have fixed ones. So you run the risk of rising rates with a HELOC.
- HELOCs tend to have lower interest rates than HELs. But your personal creditworthiness and financial health may influence your rates even more.
- HELs are straightforward installment loans. You pay them down in equal installments.
- HELOCs come in two phases. The draw period is when you can borrow, repay, and reborrow. But then comes the repayment period, during which you can’t borrow anymore. You must pay it off little by little via monthly payments, or refinance it into another loan.
Home equity loan, HELOC or cash out refi: Which is best?
Which is best has as much to do with your needs as each mortgage loan’s characteristics. Pick the one that meets your requirements best, bearing in mind the following:
- The mortgage rates. Typically, cash out refinances have the lowest rates, followed by HELOCs and then HELs.
- The closing costs. This time, cash out finances are usually most costly, followed by HELs and then HELOCs. Run the numbers to see which combination of rates and costs suits you best.
- How much you want to borrow. Mortgage lenders will normally borrow up to 80% of the equity you have in your home with all of these. But cash out refinances and HELs provide a lump sum while HELOCs let you draw down from a line of credit.
- What you’ll do with the money. HELs and refinances are best for lump sums. But HELOCs are great for freelancers, contractors and others in the gig economy. You can borrow in lean months, repay in good months and borrow again when times turn hard again. HELOCs are also good for those who want large sums for a short time. You only pay interest on the outstanding balance.
- How long you plan to stay in your home. The sooner you’ll be moving on, the more you’ll want to keep your closing costs lower. They’ll be wasted when you sell and get a new mortgage. So a HELOC, with its low or zero closing costs, may be better in those circumstances.
- Your risk tolerance for rising interest rates. Rates have been low and generally falling for more than a decade but that’s no guarantee they’ll stay that way. If you opt for a HELOC, which usually has a variable rate, you’ll be on the hook if they rise. HELOCs are usually based on the prime rate, currently 3.25%. Great borrowers get prime + 0%. Prime rate has been as high as 5.5% in recent years, and much higher in the past. Make sure you can still afford a rate that goes up 2-3% in coming years.
Of course, we’re talking generalities here. For example, you can find HELs with variable rates. And you could choose an adjustable-rate mortgage (ARM) for your cash out refinance.
Pros and cons of a cash out refinance
Pros of a cash out refinance
Why might you choose a cash out refinance rather than a HELOC or HEL? Well, there are several possible reasons:
- Lower mortgage rates. These refinances typically have lower interest rates than home equity loans, but not always than HELOCs.
- More flexibility. You can choose the type of mortgage that suits you: conventional, FHA, VA, jumbo. But you can’t do a cash out refinance on a USDA loan.
- Lower monthly payments. You can spread payments over 30 years, which is a longer loan term than most home equity loans or lines of credit. The more payments, the lower each needs to be. Home equity loans — but not HELOCs — can also last 30 years but they’re usually for a shorter period of time.
Those are compelling advantages for many borrowers. But here are the drawbacks.
Cons of a cash out refinance
Cash out refinancings have some disadvantages you should take seriously:
- You’re resetting the clock on your mortgage balance. Suppose you’ve had your existing 30-year mortgage for 10 years. Get a 30-year cash out refinance and you’ll be paying down your home for 40 years: the 10 you’ve already done and the 30 on the new loan. If you can afford the payments, opt for a 15- or 20-year term.
- You may pay more in the end. Even with a lower interest rate, borrowing (and paying interest) for so long is expensive. Your total cost of borrowing will likely be lower with a shorter home equity product. Unless, that is, you can afford the higher payments that come with a 10-year, 15-year or 20-year cash out refinance.
- Closing costs are higher than for home equity products. If you plan to move in the next few years, those higher costs could make a cash out refinance too expensive.
- Your new loan could have a higher rate than your existing one. That’s less likely at a time when rates are falling. But cash out refinances often have slightly higher rates than straight refinances when your only benefits are a lower rate and a smaller monthly payment.
- You might have to pay mortgage insurance. This is rare because most lenders require you to keep a 20% equity cushion that lets you avoid those premiums. But if you find one that lets you borrow more than 80% of you home’s value, you will have to pay mortgage insurance.
Cash out refinances remain a very popular way to get cash from the value of your home.Speak with a mortgage specialist about a cash out refinance today.
Pros and cons of home equity lines of credit (HELOCs)
Although HELOCs and cash out refinances both let you access money that’s tied up in your home, they’re typically used for very different purposes. So let’s look at the tradeoffs:
Pros of home equity lines of credit (HELOCs)
For the right borrower, HELOCs have some impressive advantages:
- Typically lower closing costs than a cash out refinance or home equity loan. Sometimes those costs are zero. The lower upfront costs could make a HELOC a good option, even if you intend moving in a year or two.
- May be eligible for tax deductions on your interest payments. But only if you use the money for certain types of home improvements.
- Low rates. Typically appreciably lower than for a HEL. Sometimes these rival cash out refinance rates.
- Borrow large amounts. This depends on the amount of equity but you’re likely able to borrow much more than with a credit card or personal loan.
- Flexibility. Borrow, repay and borrow again at will up to your credit limit. And only pay interest on your balances. Great for those with constantly changing incomes. And for those who want to borrow big sums for short periods.
Cons of home equity lines of credit (HELOCs)
So what should you be wary of? Here are some potential drawbacks:
- Higher interest rates. Not all HELOC rates can compete with refinance ones.
- Shorter terms. HELOCs often come with terms of five to 10 years. And shorter terms mean higher monthly payments, compared with cash out refinances and some HELs.
- Two mortgage payments. This applies to HELOCs and HELs which are both are in addition to your primary mortgage. A second mortgage means a second monthly payment.
- Variable interest rates. After more than a decade of downward trending rates, we sometimes think interest rates can move only one way. But that’s not true. And current economic uncertainty could eventually lead to higher rates. If that happens when you have a HELOC, your loan could become high-interest debt and you’ll have to pay more and make higher monthly payments.
- Repayment periods. After a set number of years, your draw period will end and your repayment one begins. Some borrowers experience difficulties at that point. They can’t borrow anymore and they have a fixed time within which to pay down their balance. Unless they can refinance the loan amount.
In the end, the choice between a cash out refinance and a HELOC depends on the specifics of your financial circumstances.Click here for today's refinance mortgage rates.