HELOC vs. Cash-Out Refi

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If you're a homeowner and you need some extra cash — whether to finance a renovation or to get you through a financially tough spot—you may be able to use the equity in your house to obtain the money you need. Two ways of tapping that source are a home equity line of credit (HELOC) and cash-out refinancing.

Keep reading to learn the differences between these two options and see which one might be a good fit for you.

HELOC vs. cash-out refinance

There are several similarities between using a line of credit and refinancing your existing mortgage. Both options rely on an increase in your home’s value to provide a source of extra cash. Because both are types of mortgages, they rely on your home as collateral to guarantee repayment - which means you can be at risk of foreclosure if you can’t make your monthly payments or pay back the line of credit.

While the two options have similarities, they also have several differences, particularly in how you access your home equity, the interest rate you’ll pay, and how you pay the loans off. Knowing exactly how each type of loan works, as well as their pros and cons, will help you decide which one best suits your needs.

What is a HELOC?

If you already have a mortgage loan, a HELOC or home equity line of credit is a second mortgage, similar to a home equity loan, that uses your property as collateral. Unlike a loan, however, a HELOC works like a credit card and other types of revolving credit: you receive a maximum credit line and can borrow, repay and borrow again up to that maximum amount for a predetermined number of years. HELOCs are often used as an emergency fund, to be used only when necessary.

So why not just use a credit card and leave your house out of the equation? Because a HELOC is a secured loan that uses your home as collateral, which means the bank assumes a lot less risk. Credit cards are unsecured “loans” with no collateral. As a result, credit cards often charge a much higher interest rate than home equity lines of credit, and your credit limit could be lower than what you could access through a line of credit (it all depends on how high your credit score is, among other factors).

But there are other reasons why a homeowner may choose a HELOC over a credit card.

How does a HELOC work?

The credit limit the bank will offer you with a HELOC is determined by the amount of equity you have in your home. When you apply for a HELOC, the bank will typically have your home appraised. For example, if your home is assessed for $250,000 and you still owe $100,000 on your mortgage, that means you have $150,000 in equity. This doesn't mean you'll be granted a credit limit of $150,000, though. HELOCs are generally offered for up to 85% of your home's equity. Therefore, in this scenario, you'd be granted access to a $127,500 line of credit.

Most HELOCs will have a 30-year term which is divided into two phases: the draw period and the repayment period.

The draw period

Once the lender has approved your line of credit, you can access the funds during the draw period. You can take out as much or as little money as you need, up to the maximum amount of the credit line. There are no limitations on how you can use the withdrawn funds: you can make home improvements, pay off higher-interest debt or keep the line of credit as an emergency fund.

During this period, which typically lasts for 10 years, you’re required to pay only the interest on the amount withdrawn, not the whole credit line. You can repay the amount you take out and replenish the line of credit or make interest-only payments until the draw period ends.

The repayment period

Once the draw period ends, the repayment period begins. During this time, you will have to pay interest and principal on the amount of the credit line that’s outstanding. If you have repaid the line of credit by the time the draw period ends, you won’t have to pay anything.

However, you will no longer be able to access the line of credit during this time. Most HELOCs have a repayment term of 20 years, but some lenders may have shorter (or longer) terms.

What is a cash-out refinance?

A cash-out refinance, on the other hand, is a type of mortgage refinancing that allows you to convert some of your home’s equity into cash. You’re basically replacing your original mortgage with a new loan and for a larger amount.

Part of the proceeds from the new cash-out refinance loan is used to pay off any outstanding mortgage balance on your existing loan. The excess amount is paid to you directly in the form of a lump sum payment. As with a HELOC, there is no limitation on how you can use the money.

As a result, the equity you have in your home will decrease, but you'll have cash on hand without having to take out a personal loan or open up a new line of credit. A cash-out refinance differs from a traditional home refinance, where you're essentially just obtaining a new mortgage to get a better interest rate or longer repayment period. If you're looking for a simple traditional refinance and don't need money upfront, check out our picks for the best mortgage refinance options.

How does a cash-out refinance work?

When you apply for a cash-out refinance, the lender will require a new home appraisal to determine your home’s value and how much equity you have. Most mortgage lenders will require that you keep at least 20% equity in the home when you refinance, which means they are willing to approve a cash-out amount up to a maximum of 80% of your equity. This is called having a loan-to-value ratio of 80%.

Returning to the previous example, let's say the person with $150,000 in equity in their $250,000 would be able to get a maximum cash-out amount of $120,000 (80% of $150,000). If they needed only $50,000 in cash for an emergency medical expense, they would be able to refinance and have $100,000 remaining in home equity.

It’s important to understand that opting for a cash-out refinance doesn't mean your old mortgage is simply adjusted. Rather, your mortgage is replaced with an entirely new loan. If interest rates have risen since you secured your previous mortgage, you'll likely find yourself paying more each month than you did before. While a traditional refinance typically lowers your monthly mortgage payment, a cash-out refinance tends to have the opposite effect.

What is the difference between a HELOC and cash-out refinance?

Still not sure which option is right for you? While a HELOC and cash-out refinancing both make use of your home equity, they're structured very differently and have different sets of pros and cons. Here's everything to know about the differences between a HELOC and a cash-out refinance.

Loan structure

While HELOCs and cash-out refinancing might seem confusing at first, once you understand the basics, the difference between the two is pretty simple. A good way to compare a HELOC and cash-out refi is to think of credit cards vs. debit cards.

A HELOC operates like a credit card, granting you a line of credit with a limit, and you can borrow up to that limit as often as you'd like for the agreed-upon term. HELOCs and credit cards are both revolving lines of credit. A HELOC doesn’t replace your primary mortgage but is considered a form of secondary mortgage.

On the other hand, think of cash-out refinancing like a debit card. The only difference is that when you take money out, it's coming from the equity in your home instead of your bank account, and part of the new loan is used to pay off your previous mortgage balance.

There are some similarities as well. The maximum amount of money a lender is willing to provide through a line of credit or cash-out refinance depends on your credit score, debt-to-income ratio and other financial information.

Loan interest rates

In general, a cash-out refinance will have a fixed interest rate, which means it will always stay the same. Some lenders may offer an adjustable or variable interest rate, which means the interest rate on a loan will vary according to market conditions and change at preset intervals.

While having a good credit score usually results in a lower rate, the loan amount can also affect your mortgage rate. The more money you “cash out” of your home equity, the higher the rate.

When it comes to a HELOC, most mortgage lenders only offer an adjustable rate, which means the interest rate on the line of credit will change over time. (Some lenders may offer a fixed-rate option.) Generally speaking, HELOCs have a lower rate than those offered on other types of revolving credit — like credit cards — as the bank assumes less risk since your home is used as collateral.

Because cash-out refinances are primarily fixed rate loans, they tend to have lower interest rates compared to HELOCs.

Repayment terms

The money you get from your cash-out refinance doesn't need to be paid back as you would with a HELOC. But since you are taking out a new mortgage, you will be making monthly mortgage payments, just as you do with your current mortgage. Since you have a new loan term and mortgage interest rate, you could be making payments on your home for longer than the previous mortgage’s term, and for higher monthly amounts.

During a HELOC’s draw period, you’ll make monthly payments on the amount borrowed, much as you do for a credit card, but these payments only go toward the interest, not the principal.

The end of the draw period is when things can get tricky. Some banks offer HELOCs on a balloon repayment plan, which means that at the end of the draw period, the entire loan (interest and principle) is due. If you have any doubts about whether you'll be able to make such a large payment, avoid any HELOC with a balloon repayment plan. Remember: Your home is collateral, and the bank can claim it should you fail to meet your end of the agreement. Thankfully, most HELOCs allow you to make monthly payments after the end of the draw period until your debt is repaid.

Flexibility and access to funds

With a cash-out refinance, you're given a lump sum of cash. Once the money is in your account, you can access it however and whenever you like. With a HELOC, you can access your line of credit whenever you need to, provided you haven't reached your limit or missed any monthly payments. If you think you're going to miss a loan repayment, contact your lender as soon as possible. Remember, your home is acting as collateral, so you should never go incommunicado if you find yourself in a troubling financial situation.

Closing costs

HELOCs and cash-out refis involve closing costs, which typically range between 2% and 5% of the total loan amount. These closing costs include origination fees, which are the fees you pay to secure the loan or line of credit and also include the cost of your initial appraisal, application fees and any other costs associated with setting up the loan.

Inherent risks

If you find yourself in a tricky financial spot, a cash-out refinance can be just the help you need, but it isn't without potential risks. By refinancing and taking out a new loan, you'll likely end up with higher mortgage payments. Furthermore, should the market value of your home plummet due to unforeseen circumstances, you could end up owing more than your home is actually worth. This situation is what's known as being "underwater" on your mortgage.

Finally, if you find yourself in financial trouble and can no longer make your monthly mortgage payments, you run the risk of foreclosure, since your home serves as collateral for the refinance loan.

Similarly, a HELOC has both pros and cons. While it's a great way to access a line of credit that can help you in a pinch, you're still leveraging your home as collateral. Should you find yourself in a troubling financial situation wherein you can't make repayments on the loan, the bank can take your home.

This is why a HELOC or a cash-out refinance may not be an ideal choice if you’re already in dire financial straits. While you might get the money you need, you're risking one of your most valuable assets: your house.

Summary of Money's HELOC vs. cash-out refi

You can utilize a HELOC or a cash-out refinance to make the equity in your home generate money for you. While both a HELOC and cash-out refinance may help with home renovations or an emergency financial situation, both carry risks. You’re leveraging your home as collateral and could potentially lose it should you fail to repay the loan. You’re also losing equity in your home. When push comes to shove, you should carefully weigh the risks of both options before making a decision. A HELOC or cash-out refinance can be a smart financial move if done wisely, so make sure you thoroughly understand both options before proceeding with either.