Your home is your biggest asset, and it can also be your best source for paying off expenses or paying down high-interest debt. The longer you live in your home, the more equity you have to use. Three ways that homeowners can access their home’s equity are through a HELOC cash out refinance or home equity loan. We’ll help you learn more to compare each of these options along with their pros and cons so that you can make the best decision for your needs.
What is a HELOC?
To understand how a HELOC differs from a cash out refinance or home equity loan, it’s important to know how it’s structured. HELOC stands for Home Equity Line of Credit and it is similar to taking out a second mortgage, but like a credit card, you have an open line of credit to withdraw money from. The amount is determined by a mortgage lender, but it is based on your home’s equity. Unless there is a minimum draw requirement, you don’t have to take out a specific amount as a lump sum, but you can take out cash up to a certain limit when you need it.
Some lenders have minimum draw requirements so you may have to take out a minimum amount even if it is more than you need at the time. Your home is used as collateral for the money you borrow and the interest is variable like an adjustable rate mortgage, which means your monthly payment can increase.
Something else to note is the term of repayment for a HELOC is different than a cash out or home equity loan. For a HELOC you can draw the funds within a 5-10 year period and repayment usually happens between 10 and 20 years. When you are drawing funds, you only pay interest on the amount withdrawn, however, the repayment period includes payments of principal and interest, which will increase your monthly payment substantially.
Pros of a HELOC:
- Interest rate for a HELOC can be lower vs a cash-out refinance.
- Flexibility of interest-only payments during the initial draw period.
- No closing costs.
Cons of a HELOC:
- Interest rates could rise and result in a higher payment.
- Potential for annual fees and charges for non-usage may be incurred.
What is a cash out refinance?
With a cash out refinance you refinance your home, but instead of just refinancing your remaining loan amount, you take out a new loan for more than you owe on the home and receive the difference in cash. There are many reasons to consider a cash out refinance over a HELOC or a home equity loan, as that cash could be used to pay down high-interest credit card debt, for home improvements, to pay for a car or other big expenses such as college tuition, or any other reason.
A cash-out refinance could allow you to lower your interest rate or change the loan term in addition to getting out cash. Using the cash out proceeds to pay off higher interest debt (i.e. credit cards) may lower your total monthly debt payments and increase your cash flow.
Pros of a cash out refinance:
- Only have one loan and one monthly payment since the cash out refinance replaces your existing mortgage.
- Fixed interest rates vs a HELOC, where the interest rates could rise.
- The interest paid may be tax deductible. Consult with a tax professional.
- A cash out refinance can be a good option for those with less than perfect credit.
Cons of a cash out refinance:
- Like a new home loan, you need to go through the underwriting approval and closing process and upfront costs will be charged.
- It may take you longer to pay off your mortgage if you don’t reduce your term.
- Your monthly mortgage payment could go up with a cash out refinance, vs a home equity loan where your monthly payments are the same.
- You borrow one lump sum and start paying off immediately.
What is a home equity loan?
A home equity loan is a second mortgage which allows you to use your home’s equity as collateral to borrow money against it. With this type of loan you get the money as a lump sum and have a fixed interest rate.
Pros of a home equity loan:
- Fixed interest rate.
- Monthly payments are the same each month.
- Interest paid may be tax deductible. Consult with a tax professional.
Cons of a home equity loan:
- Interest rate is typically higher for a home equity loan vs. a cash out refinance or HELOC.
- Since your home is used as collateral, if the housing market declines, you could end up owing more than your home is worth.
- You get a lump sum and have to pay interest on the entire amount unlike a HELOC where you take out what you need and pay interest on only what you’ve withdrawn.
HELOC, home equity loan and cash out refinance comparison
When trying to decide if a cash out refinance, HELOC or home equity loan is the right choice for you to tap into your home’s equity, it’s important to compare benefits and fees and determine which option is right for your financial needs.
Still have questions? Call a licensed Freedom Mortgage home loan specialist today or visit our get started page to learn more about our home loan options!