Cash-Out Refinance vs. HELOC vs. Home Equity Loan: Which Should You Choose?
If you’re considering a cash-out refinance versus a HELOC or home equity loan, knowing how each of these equity-tapping loans works will help you make a cost-effective choice toward your financial goals. A cash-out refinance and a home equity loan allows you to convert home equity to cash at a fixed interest rate and stable monthly payment, while a home equity line of credit (HELOC) gives you more flexibility.
We’ll cover the pros and cons and moving parts of each option so you can decide which product fits your needs.
Cash-out refinance vs. HELOC
When comparing a cash-out refinance versus a HELOC you need to determine how much home equity you have, and whether you’re using the equity to meet short- or long-term financial goals. Home equity is the most important factor with either option: If you don’t have enough equity, neither will be possible.
Home equity is the difference between how much your home is worth and how much you owe on your mortgage. For example, if you owe $250,000 on a home worth $350,000, you have $100,000 worth of equity ($350,000 – $250,000 = $100,000). However, lenders usually don’t let you borrow all your equity, and there are different requirements for cash-out refinances and HELOCs.
What is a cash-out refinance?
A cash-out refinance replaces your current mortgage with a new home loan that has a larger loan amount, allowing you to pocket the difference in cash. If current mortgage rates are low, a cash-out refinance may make the most sense to snag the lowest monthly payment. Most cash-out refinance borrowers choose a 30-year term to spread out the costs over a longer time period.
To get approved for a cash-out refinance, you’ll typically need to meet the following requirements:
- LTV ratio. Your loan-to-value (LTV) ratio measures how much of your home’s value you’re borrowing. You’re typically limited to borrowing 80% of your home’s value with a cash-out refinance. However, eligible military borrowers can borrow up to a 90% LTV ratio to tap equity with a loan backed by the U.S. Department of Veterans Affairs (VA).
- Credit score. Loans backed by the Federal Housing Administration (FHA) allow for scores as low as 500, but you’ll need at least a 620 score for conventional and most VA loans.
- DTI ratio. Lenders divide your total monthly debt payments by your income to calculate your debt-to-income (DTI) ratio, and most cash-out refinances set the maximum at 50%.
Cash-out refinance pros and cons
| Pros | Cons |
|---|---|
| You’ll have a lower rate than a HELOC | You’ll pay higher costs because your loan amount is higher than a HELOC |
| Your interest rate is typically fixed | You can’t access additional funds without refinancing again |
| You’ll borrow all your money at once | You may start your loan term over |
| You’ll only have one monthly payment | You can’t borrow as much equity as HELOCs allow |
What is a HELOC?
A home equity line of credit (HELOC) works more like a credit card than a regular home loan. You won’t have a fixed payment, your payments aren’t made on a set amortization schedule and you don’t receive your funds in a lump sum. A HELOC is also considered a “second mortgage,” because you’ll take it out on top of your primary home loan, meaning you’ll make two house payments.
Homeowners often choose HELOCs because they can use the balance and pay it off during a set time called a draw period, which is typically 10 years. Payments are only made on the amount drawn, and HELOC lenders often offer interest-only payment options, which keep monthly costs low.
To get approved for a HELOC you’ll need to meet the following requirements.
- CLTV ratio. Lenders have to calculate your “combined-loan-to-value” (CLTV) ratio, which adds the balance of the HELOC you borrow to the balance of your current mortgage and divides it by your home’s value. For example, if you take out an $80,000 HELOC and owe $200,000 on a home worth $350,000, your CLTV ratio is 80% ($200,000 + $80,000 / $350,000 = 80%). Most HELOC lenders cap your CLTV ratio at 80%.
- Credit score. Although HELOC lenders allow scores as low as 620, your rate will be much lower if you have a 740 score or higher.
- DTI ratio. Most HELOC DTI ratios are capped at 50%, but lenders may reduce your maximum CLTV depending on your credit score.
HELOC pros and cons
| Pros | Cons |
|---|---|
| You can use the credit line and only make payments on the balance used | You’ll usually have a variable interest rate |
| You may be able to make interest-only payments | You’ll have two monthly house payments |
| You can tap equity without affecting your current mortgage | You may face potential prepayment penalties, ongoing account charges and annual fees |
Cash-out refinance vs. HELOC: What’s the same and what’s different
| You could lose your home to foreclosure if you default |
|---|
| You could lose your home to foreclosure if you default |
| You may be able write off mortgage interest for any funds used on home improvements |
| You can choose a repayment term up to 30 years |
| You can roll closing costs into your loan |
| You have to qualify based on your income, credit, assets and home's value |
| You’ll use up available equity in your home |
| Cash-out refinance | HELOC |
|---|---|
| You get your cash all at once | You can withdraw funds and pay them off as needed |
| Your payment includes principal and interest | Your payment starts off as interest only |
| You can qualify with a score as low as 500 | You must have at least a 620 credit score to qualify |
| You typically need at least 20% equity | You typically need at least 15% equity |
| You’ll get a lower rate than a HELOC | Your rate will be higher than a cash-out refinance |
| You’ll typically have a fixed interest rate | You’ll usually have a variable rate |
Cash-out refinance vs. home equity loan
A home equity loan is very similar to a cash-out refinance. You’ll receive the loan funds in a lump sum and normally pay a fixed rate for the life of the loan. Like a HELOC, a home equity loan is a second mortgage, which means you’ll have two house payments. You can also deduct the interest from your taxes if you use the home equity loan for home improvements.
Because it’s secured by your home, if you default you could lose your home. The biggest difference is you’ll leave your current mortgage balance alone, and only borrow against the equity you need, which means a smaller loan amount and monthly payment, plus fewer closing costs than a cash-out refinance.
Home equity loan pros and cons
| Pros | Cons |
|---|---|
| You’ll leave the balance of your current first mortgage alone | You’ll pay a higher rate than a cash-out refinance |
| Your costs will be lower because you’ll borrow less | You’ll need a higher credit score for approval than a cash-out refinance |
| You’ll have a stable, fixed-rate monthly payment | You’ll make two monthly house payments |
Should I get a cash-out refinance, HELOC or home equity loan?
To help you make a decision about a cash-out refinance versus a HELOC versus a home equity loan, we’ve highlighted how each option can meet your financial needs:
| A cash-out refinance makes sense if: | A HELOC makes sense if: | A home equity loan makes sense if: |
|---|---|---|
| You want the lowest possible payment | You want an interest-only payment option | You’re borrowing a small loan amount |
| You have lower credit scores | You have higher credit scores | You have higher credit scores |
| You want a fixed, stable monthly payment | You don’t need all the funds at once | You want a fixed, stable monthly second mortgage payment |
| You want just one monthly mortgage payment | You can manage two house payments | You can manage two house payments |
| You can get a lower rate on the new mortgage than you currently have | You want to be able to pay off and reuse funds as needed | You want to leave your first mortgage balance alone |