If you need cash but don't want to dip into your emergency fund, one of the best ways to get some liquidity is by tapping into your greatest asset—your home equity.
You can use the money anything—remodeling your home, consolidating your debt, unforeseen expenses like a sudden medical bill, or even to pay other expensive bills like your kids' college tuition.
There are several ways to tap into your home equity, so it's important to compare your available options before choosing the right fit for you. Two of the more popular ways are a cash-out refinance and a home equity line of credit (HELOC). What are the differences between them and which one is best for you? Here's the breakdown.
What is Cash-Out Refinance?
A cash-out refinance is the process of replacing your existing mortgage with a new one, typically with more favorable terms. The new mortgage is for a larger amount than the original mortgage. You can typically tap into up to 80% of your home equity with a cash-out refinance.
What is HELOC?
A home equity line of credit (HELOC) is a revolving source of funds offered as a loan, where the equity on your home is the collateral. It is similar to a second mortgage, but it offers a line of credit to borrow from as needed, like a credit card. You can typically borrow about 85-90% of your home equity through this method.
What Are the Differences Between the Two?
A cash-out refinance differs from a home equity line of credit (HELOC) based on:
Cash-out refinance pays off your first mortgage. This results in a new mortgage with different terms than the original mortgage. The changed terms may include a higher or lower interest rate or a longer or shorter period for paying off the loan.
HELOC is taken in addition to the first mortgage. Your first mortgage remains with the same loan terms. A HELOC is like a second mortgage with new terms, but with revolving debt. You can withdraw what you require when you require it and repay it as per the terms of the HELOC.
Cash-out refinancing typically has a fixed interest rate that may be lower or higher than the interest rate on your current mortgage. The interest rates on cash-out refinance are usually lower than those on a HELOC or a home equity loan.
HELOC has a variable interest rate that depends on an index, commonly the U.S. Prime Rate as published in the Wall Street Journal. So, the interest rate will increase or decrease when the index rises or falls. The interest rate on a HELOC is also likely to be higher than the rate on your initial mortgage.
How the Funds Are Received
Cash-out refinance is given as a lump sum when it is approved. The proceeds are first used to pay off your existing mortgage including closing costs and any additional prepaid terms. The remaining funds are yours to spend.
HELOC is available as a line of credit that you can withdraw from as needed during your draw period, which is usually 10 years. During the draw period, you need to make monthly payments, much like credit card payments. After the draw period, you can no longer draw funds and the repayment continues. Many lenders have a minimum draw requirement, which means you have to withdraw a minimum amount even if it's more than you need at the time.
Cash-out refinance incurs closing costs similar to the first mortgage. The costs can be quite high, ranging from 2% to 7% of the loan amount.
HELOC often has no closing costs at all. Even if you incur closing costs on a HELOC, they are significantly lower than those of traditional mortgages.
When to Use Cash-Out Refinance
You can use cash-out refinance in the following situations:
- Refinancing offers lower interest rates. If your current mortgage has a relatively high-interest rate and a cash-out refinance would help you save on interest and your savings outweigh the fees that come with refinancing (like extra closing costs), it may be the best option for you.
- You prefer single, fixed payments. If the stability of fixed monthly mortgage payments appeals to you or you don't wish to make multiple mortgage payments every month, a cash-out refinance offers the predictability you need.
- You wish to consolidate your debt. If you're paying multiple high-interest debts every month, you can combine them at a single rate with a cash-out refinance.
- You need a large amount of money fast. A cash-out refinance gives you a lump sum with a fixed interest rate, which is helpful if you have a specific large-scale spending need.
- You want a tax-deductible option. A cash-out refinance is typically tax-deductible, which is helpful if you're looking to save on taxes.
When to Use HELOC
HELOCs are useful in the following situations:
- You aren't sure how much money you need. If you need money but you're not sure about the amount, you might prefer the flexibility of a secure line of credit that a HELOC provides.
- You're happy with your current mortgage. If you're comfortable with your current mortgage and you don't want to trade it for a new one, or your current mortgage has a lower interest rate than you can currently qualify for, a HELOC as a second loan may be better suited for your needs.
- You want to be able to borrow a higher amount. A HELOC allows you to borrow 85-90% of your home equity while a cash-out refinance typically limits your borrowing at 80%. So if you wish to tap into more of your home's equity, a HELOC might be a better option for you.
Cash-out refinance and HELOC are both effective ways to tap into your home equity for your various spending needs. But it's always advisable to carefully assess your options before choosing either of them. If you're unsure about which to choose, a Fifth Third Advisor can help you decide which type of loan would be appropriate for your situation.