What Are the Differences in a HELOC Loan and Cash-Out Refinance?

Your home where you live, but it is much more than that. It is an investment but also can be a source of cash if you want it. Mortgage rates have dropped a lot in March 2020 amid economic uncertainty. Many homeowners are rushing to pull equity out of their homes while rates are so low.

Does this apply to you? Well, if your home is worth more than what you owe on your home loan, you have equity in the property. If you aren’t sure, ask your realtor to run the latest comps in your neighborhood.

After eight years in a row of median home prices rising, you have a good shot of being one of the millions of homeowners with equity available. The real estate data analytics company Black Knight reports the average equity held in those homes is $120,000. (USAToday.com)

If you have equity, one thing you need to decide on is if you want to get a home equity line of credit (HELOC) or a cash-out refinance to tap your equity. It’s smart to understand the advantages and the disadvantages of each loan so you can choose the right financial option.

HELOC Overview

A home equity line of credit is a second mortgage on your property. It is similar to a line of credit you have on a credit card, but the loan is secured by your home. The rate is usually much less than personal loans and credit cards. But the lender may be able to take your home if you don’t pay the loan, so use caution.

With a HELOC, for a term of five or 10 years, you can borrow as much or as little on your approved credit line as you like. You could have to pay a fee each time you pull out cash, or an inactivity fee if you do not use it during a period.

During your draw period, you will pay interest only on what you have taken out. At the end of the draw period, your credit line closes and you start paying back the interest and principal.

A HELOC is called a second mortgage because you have taken another loan on the equity you have in the home. The HELOC is subordinate to your first mortgage. If you do not pay, the second lender is behind the first to collect proceeds during foreclosure. This is why HELOC rates are higher than for first mortgages: The lender is taking on higher risk.

A HELOC has an adjustable-rate after the draw period that is usually tied to the prime rate. If you are risk-averse, you may be more comfortable with a home equity line second mortgage with a fixed rate. Or, go with a cash-out refinance if you can lower your rate.

Cash-Out Refinance Overview

There are two options with a refinance – a rate and term refinance and a cash-out refinance. A rate and term refi only pay off the old loan with the funds from a new loan but at a lower rate.

The cash-out refinance does the same thing but also takes out a portion of your equity and puts it in your pocket. When the new loan closes, you have a new first mortgage and a check for cash.

Your closing costs will be 2% or 3% of the new loan amount. This can amount to several thousand dollars on many mortgages, so you should plan to stay in the house for a few years if you choose a cash-out refinance. (Investopedia.com)

Not planning to stay in your home for the long haul? A HELOC might be a better option because the closing costs are lower.

HELOC vs. Cash-Out Refinance Example

Say you bought your home in 2010 when rates were 5% on a 30-year fixed-rate mortgage. Now you can get a rate of just 3.5% on your new loan. That is a full 1.5% less, so you could reduce your mortgage payment by hundreds of dollars per month. The new loan also would cut the interest you pay over the life of the loan by tens of thousands.

If you are going to stay in your home for a few years, doing a cash-out refinance may be a good move.

But what if you already have a 3.5% rate on your first mortgage? You just want to pull out some cash to renovate your kitchen and add a new deck to the back of the home. You may be better off with a home equity line of credit.

Considerations

Your ability to get approved for a HELOC or a cash-out refi hinges on your credit score. If your FICO score is lower than when you bought the house, you may not want to refinance; your rate could end up higher than you have now. Talk to your mortgage lender about your possible rate if your score is not 740 or higher.

Final Thoughts on Differences in a HELOC Loan and Cash-Out Refinance

HELOCs and refis can be a boon to homeowners who want to pull out cash for things they want or need, especially when rates of low. To determine which loan is right for you, think about these factors:

  • How much equity you have
  • What you want to do with the money
  • Your current interest rate vs current market rates
  • How long you want to stay in the house
  • Your risk tolerance – a fixed-rate 30-year mortgage offers more stability, while a HELOC could have a low rate for a time that may increase in the future

References

Author: Bryan Dornan

Bryan Dornan is a financial journalist and currently serves as Chief Editor of Cash Out Refi Tips.com. Bryan has worked in the mortgage industry for over 20 years and has a wealth of experience in providing mortgage clients with the highest level of service in the industry. He also writes for RealtyTimes, Patch, Buzzfeed, Medium and other national publications. Find him on Twitter, Muckrack, Linkedin and ActiveRain.

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