Cash-out refi vs home equity line of credit. What’s the difference?
Pros & cons of cash-out refinancingCash-out refinancing allows a homeowner to borrow some money and refinance a mortgage at the same time. Typically you might do this when the market is such that interest rates are lower than when you took out your mortgage in the first place. That would make your monthly mortgage payment a little lower, and then you borrow a bit extra on top of that against whatever equity you've already built up in your home. Depending on your situation, your new monthly payments might not be far off from your current payments, but you'd get a nice fat check at closing. What's required:
- You'll need to meet most of the requirements you did when you were applying for a first mortgage (this typically means having a regular source of income, tax documents for a few years back and a good credit score).
- Your lender will look for a debt-to-income ratio of less than 43% (i.e., the sum of all recurring debt, including housing-related expenses, divided by your gross monthly income.) Why 43%? It's generally assumed that borrowers with high debt levels will have trouble keeping up with their payments.
- You'll want to aim for a loan-to-value ratio that's 80-85% or less after the cash-out refinance is complete. That means you can't cash out 100% of your home equity, and you'll be required to leave about 20% intact. As a general rule of thumb, don't take out more than you need.
- Interest rates for refinancing tend to be lower than for regular mortgages, so a cash-out refi is a cost-effective way to borrow money.
- Monthly payments of credit cards and auto loans and the like can be made more manageable if you use the cash-out to pay off debt with higher interest rates. That's because the consolidated debt is stretched over a longer period (in case of a refi, it could be 30 years) at a lower rate.
- When paying credit cards and other debt, you can't deduct the interest for each payment on your taxes. But rolling other debt into your home refinance paves the way for the combined interest paid to be tax-deductible. Your tax professional can provide details.
- Your new closing costs (yes, you have to pay them with a refinance) covers not just the remaining principal owed on your home. You will end up paying closing costs on the entire loan amount, including the cash-out portion.
- There will be a new term to commit to — meaning a new timeframe in which you will pay off your mortgage. If your terms were originally 30-years and you refinance for another thirty, you're extending how long it will take to own your home outright.
- When your original mortgage closes, your payment history on that loan stops being reported. This may cause your credit score to drop briefly. But don't worry, it should regulate once your new monthly payment obligations are being met.
Pros & cons of a HELOCMany people want to understand the differences between a home equity loan vs. a mortgage. Like a cash-out refi, a HELOC lets you borrow against your home equity via a line of credit, but you keep your first mortgage exactly how it is. A home equity loan essentially acts as a second mortgage. What's required:
- To qualify for a HELOC, you must have built up at least 20% equity in your home.
- Depending on how much debt you have — and your current credit score — you can typically borrow up to 80-85% of the appraised value of your home.
- Here, too, you'll need to have a debt-to-income ratio of 43%, including the payments against your first mortgage payments and your proposed HELOC payment. It's said that 36% is the sweet spot, so if you're way over that, start reducing your debt.
- You get to keep the original terms of your mortgage intact. That's good news if your original interest rate is already low.
- You can use the money borrowed through a HELOC for anything. And it's flexible. You can pay it down — or pay it off — quickly and keep the credit line open for other items if needed.
- In general, HELOCs have lower closing costs than traditional mortgages.
- Tax deductions may apply to your HELOC if the money borrowed is used for home improvements — thus adding back into the home's value. Once again, be sure to speak with your tax professional about this.
- Taking out a home equity line of credit requires making two housing payments every month — your original mortgage payment, plus your HELOC payment.
- Interest on a HELOC isn't tax-deductible unless you use the funds to buy another property or make home improvements.
- HELOC typically have variable interest rates, and they're usually higher than rates for initial mortgages.
- You repay only against the amount borrowed, and it's hard to budget around a monthly payment since it can be paid back as fast as you like.
Home equity loan vs. refinance: which is best for you?We figured you might want to see a comparison so let's look at hypotheticals: A cash-out might be a better option:
- if interest rates are lower: refinancing at a lower rate reduces the interest portion of your monthly payments
- if you prefer only making one mortgage payment monthly at a fixed rate
- if you want to consolidate high-interest debts, so they're at the same rate as your new mortgage
- if you are comfortable with your first mortgage and don't want to trade it for a new loan
- if your first mortgage has a lower interest rate than you can qualify for today
- if you're unsure about how much money you need and want the flexibility of a secure line of credit