Did you know you can access your home equity and use the funds to use for other expenses? Often, this is done through a home equity loan (HELOC) or a cash-out refinance. Whether paying off other debts or renovating your home, the equity you hold gives you financial freedom. You just need to decide which option best suits your needs.
In this article, we’ll delve into the difference between a HELOC and a cash-out refinance to help you make an informed choice. Here’s what you need to know:
What Is Cash-Out Refinance?
When you opt for a cash-out refinance, your existing mortgage is replaced with a new one, just as with a traditional refinance. The new mortgage, however, is larger than the old one, which allows borrowers to access the home equity they’ve built up. This extra money is paid to the borrower in cash at the time of the closing. With any type of refinance, you have the option to change your loan terms, secure a different interest rate, and so on.
Well-qualified borrowers with home equity built up are generally eligible for a cash-out refinance. The lender will evaluate your property’s loan-to-value ratio, the terms of the current loan, and how much money you need to pay it off. They will also evaluate:
Amount of Equity in the House
Lenders typically require borrowers to maintain at least 20 percent of their home equity when they refinance. To receive cash from your equity, you’ll need to have more than 20 percent to start.
Your Debt-to-Income Ratio
This compares the total amount you owe each month divided by your monthly income. Typically, lenders prefer a DTI of 50 percent.
Your Credit Score
The higher your score, the better your chances of qualifying for a cash-out refinance. Usually, a minimum score of 620 is required.
What Is a HELOC?
A home equity line of credit (HELOC) is a type of second mortgage you can take out on your home. Your house is considered collateral, and the lender permits you to borrow anywhere from 60 to 85 percent of your home equity. You can think of a HELOC as similar to a credit card product where you can draw funds at your convenience as long as you are within the limit.
There are two phases of every HELOC loan:
- The draw period is 5 to 10 years, during which you can borrow up to the limit. Only interest on what you’ve borrowed is payable during this period unless the lender allows principal repayment.
- Once the draw period is over, the repayment period starts, and your borrowing ability expires. During this period, you must repay all amounts borrowed with interest.
Here’s what lenders consider for approving HELOC:
Your Home Equity
You should hold at least 15 percent equity in the property for lenders to consider your application favorably.
Your Credit Score
Since HELOCs can be riskier for lenders, a higher credit score is preferred. Pursuing HELOCs may not be fruitful if you have a credit score below 620.
Your Debt-to-Income Ratio
Most HELOC lenders prefer applicants with a lower DTI ratio, usually in the range of 43 percent or lower.
Comparing a HELOC and Cash-Out Refinance
Here are the critical differences between HELOC and cash-out refinance that may affect your decision:
- Interest rate: Interest rates for cash-out refinances are always on a fixed-rate basis and tend to be lower than for HELOCs. Some lenders offer HELOCs at variable interest rates, however, if that is your preference.
- Length of the loan: With a cash-out refinance, the term of the existing mortgage gets extended. However, a HELOC acts as a second loan, without changing the initial loan term.
- Installment amounts: In the case of HELOCs, the amount varies depending on whether it is the draw period or the repayment period. On the other hand, cash-out refinances always have a fixed monthly installment that starts when you sign up. Also, with a cash-out refinance, you make a single loan payment each month. Whereas, with a HELOC, you make two separate payments for two separate loans.
Is a HELOC or Cash-Out Refinance the Right Option for You?
There is no straight answer to this, as it depends mainly on your borrower profile. Here are some things to consider:
- If you are more at ease with a fixed-rate option, a cash-out refinance or fixed-rate HELOC is better suited, as there is more certainty about the payments. But if changing interest rates don’t impact your repayment ability, you may opt for an adjustable-rate HELOC.
- Do you have funds to cover closing costs? HELOCs do not come with additional closing costs, whereas refinancing does.
- Do you want a lump sum amount of cash for an urgent personal expense? In that case, you may be the right candidate for cash-out refinance. But if you are more comfortable accessing funds over time, HELOC can be a better choice.
- The amount you can borrow is another factor to be considered. Usually, lenders only allow borrowers to borrow up to 80 percent of their home equity for cash-out refinances. But HELOC lenders can permit borrowing up to 85 percent of your home equity as long as the draw period continues.
- Qualifying for a cash-out refinance is easier, as the new loan replaces the old one. You can quickly access a substantial amount of money that can be, in turn, used to boost your property’s value, for instance. A HELOC, on the other hand, is a loan on top of a loan. Repayment of a HELOC is second in priority, making it riskier for lenders to extend the credit line. It also poses additional risk for you as you are on the hook for paying two loans, sometimes to separate creditors.
- Lastly, consider how you plan to utilize the money. If you are unsure about how much you need or the way in which you wish to spend the funds, opt for a HELOC.
Whether you opt for a cash-out refinance or a HELOC, it is still a debt you need to repay. Choosing one that’s suited to your borrower profile is imperative. At Solarity Credit Union, an expert Home Loan Guide can help evaluate your needs and ensure that you select the home loan refinance option that fits your lifestyle, needs, and budget.