You have equity in your home and you need to tap into it, but what is the best way to do so? You have a couple of options including the cash-out refinance and HELOC (home equity line of credit). Both options provide you with cash in your hand, but repaying the loans and the costs they include will differ.
Both options have their pluses and minuses. Before you choose the option that works the best for you, read how each one works below. You can then compare it to your current situation to figure out how to proceed.
What is a Cash-Out Refinance?
A cash-out refinance involves refinancing your first mortgage. You’ll borrow more than you currently owe on your first mortgage. Any cash left after paying your current first mortgage off plus any closing fees is the cash you’ll receive. Typically, you can refinance up to 80% of your home’s value, as most lenders want to leave some collateral in the home. The only exception to this rule is the VA loan, which allows you to refinance up to 100% of the home’s value.
What is a HELOC?
The home equity line of credit is a second mortgage. You leave your first mortgage untouched, which can be beneficial if you have a great interest rate on that loan. You still tap into your home’s equity, but you take a separate loan. You may be able to tap into up to 85% of your home’s equity with a HELOC.
The HELOC works a little different than a standard loan. It’s more like a credit card or credit line than a mortgage. You receive a specific amount of money as a credit line. You can leave the money untouched and use it as needed. You only pay interest on the money you actually withdraw from the account. You also only need to make interest payments for the first 10 years of the loan’s term.
With the HELOC, you can reuse the funds as much as you need to, as long as you have the credit available. Again, it’s just like a credit card. You use the funds and repay them. Once repaid, you can use the funds again. After the 10-year draw period ends, though, you can’t use the funds any longer. At this point, you would have to make principal and interest payments to pay the loan off in the next 20 years for a total of a 30-year term.
The Benefits of the Cash-Out Refinance vs the HELOC
The cash-out refinance has its benefits including:
- You receive all of the funds at once. You can use the funds as you need to, the lender usually doesn’t have to know your intent with them. You can also place the funds in your own account so that you have easy access to them, as you need them.
- You only have one mortgage to worry about. With the cash-out refinance, you only have a first mortgage. This makes it easier to stay on top of your payments and know that you are paying the principal down.
- You can usually have a fixed interest rate. This means you’ll always know how much your mortgage payment is each month. You don’t have to worry about changing interest rates and unaffordable mortgage payments.
The Benefits of the HELOC vs the Cash-Out Refinance
The HELOC has its own series of benefits:
- HELOCs often have much lower closing costs than a cash-out refinance. There’s usually less work involved in a HELOC than a first mortgage, which means you save on the closing costs.
- You only pay interest on what you use. Even though you ‘borrow’ a larger amount, if you don’t withdraw the funds, you don’t pay interest on them. This could save you money in the long run, especially if you don’t use all of the funds.
- You may get a lower interest rate. HELOCs often start with lower interest rates than you could get on your first mortgage. Of course, the rate may be adjustable, so keep that in mind. Just ask the lender the ‘worst-case’ scenario for your interest rate so that you know what to expect.
Should you choose a cash-out refinance or a HELOC? It really depends on your situation. If you have a need for one-time funds, a cash-out refinance may be the best route. If, on the other hand, you have a project that you don’t know the full cost of yet or you see a need for funds in the future, the HELOC may offer the more flexible option.
Take a close look at what you have now to see if it’s worth touching your first mortgage or leaving it alone. If you snagged a great deal on your first mortgage or you’ve paid off a good portion of the principal, you may want to leave well enough alone. You can take out a HELOC and use those funds as necessary. If you don’t have the best interest rate on your first mortgage or you haven’t paid it down much, you may be just fine with the cash-out refinance.