Heloc vs. Cash-Out Refi

If you ever find yourself in need of money — whether to finance a renovation or to get you through a tough spot — as a homeowner, you may be able to use the equity in your house to obtain the cash you need. Two methods of doing that are through a home equity line of credit (HELOC) and cash-out refinancing.

Keep reading to learn about how these two options might be a good fit for you.

What is a HELOC?

A HELOC is a home equity line of credit, which is made available to you by a lender with your home leveraged as collateral. A HELOC isn't a one-time lump sum loan. Rather, it’s a form of revolving credit, meaning you receive a maximum borrowing amount and can borrow, repay and borrow again up to that maximum amount. In other words, HELOCs work similarly to credit cards, which are the most common form of revolving credit.

So why not just use a credit card and leave your house out of the equation? Because when you leverage your home as collateral, the bank assumes a lot less risk. If you max out a credit card and don’t make payments, the bank will have to chase you down in collections or in court to get its money.

But when your home is used as collateral, the bank can simply claim the home if you don’t repay your debt. Because banks are assuming far less risk than they would with a standard credit card, they often offer highly competitive APRs on HELOC products, which in many cases can make them a financially wiser option for homeowners.

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 by one of its assessors. 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.

What is a cash-out refinance?

On the other hand, if you need money and want to use your home's equity to your advantage, but you don't want to leverage your home as collateral, you have another option: cash-out refinancing.

Cash-out refinancing is a way for you to convert some of your home's equity into cash. 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 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?

Returning to the previous example, let's say the person with $150,000 in equity in their $250,000 home needed $50,000 in cash for an emergency medical expense. After a cash-out refinance, they would have the $50,000 in cash, but the equity in their home would now be $100,000.

It’s very 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 one. 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. HELOC and credit cards are both revolving lines of credit.

On the other hand, think of cash-out refinancing like a debit card. The only difference is that when you take money out, instead of that money coming from your bank account, it's coming from the equity in your home.

Loan interest rates

While a cash-out refinance may come with some fees, it doesn’t involve interest rates as it's not a loan. While you might find yourself paying more each month towards your mortgage, once any origination fees are paid, the money from the cash-out refinance is yours free and clear.

When it comes to a HELOC, the interest rates you'll pay will vary depending on lenders and the current rate environment. Generally speaking, the rates offered on HELOCs are more attractive 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.

Repayment terms

The money you get from your cash-out refinance doesn't need to be paid back. But, since the equity in your home will be reduced, your new mortgage could have you making payments on your home for longer than the previous mortgage’s term, and for higher monthly amounts.

When you take out a HELOC, you're granted something called a draw period. The draw period is how long you have access to a line of credit, which is typically around 10 years, although some banks offer longer timespans. During the draw period, you still have to make monthly payments on the amount borrowed, much as you do for a credit card, but these payments are generally small and 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 at the end of the draw period until your debt is repaid. If you were a responsible borrower during the draw period, you may even be offered a new HELOC.

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

Many HELOCs involve closing costs, which are typically around 5% of the total loan. These closing costs include origination fees, which are the fees you pay to secure the HELOC and cover the cost of your initial appraisal, application fees and any other costs associated with setting up the loan. Cash-out refinancing often involves similar closing costs, including the cost of appraising your home. What you pay for these closing costs will vary depending on your lender.

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. While a cash-out refi can provide you with the money you need in a pinch, 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.

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 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. With a HELOC, you're leveraging your home as collateral and could potentially lose it should you fail to repay the loan. With a cash-out refinance, you're 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.