Choosing between a cash-out refinance and a HELOC

Owning a home is a wonderful achievement. And one of the benefits is that homeownership itself can give you a way to handle a large expense. Sometimes those large expenses are planned (think kitchen remodel) and sometimes they are unexpected (think medical bills). Either way, you may be able to access the cash you need through a home equity line of credit (HELOC) or a cash-out refinance loan. Let’s explore each option.

Two ways to borrow against your home equity

When you want to access cash based on your home’s value, a HELOC and a cash-out refinance mortgage loan are two options you have.

What is a home equity line of credit (HELOC)?

A HELOC is a home equity loan that you don’t have to take in one lump sum. Instead, you get a credit limit. You can borrow what you need, when you need it, up to your limit. If you pay down your balance, you can borrow more, up to your limit.

Today you have the option of choosing a traditional, hybrid, or fixed-rate HELOC. Here are the similarities between them:

• All HELOCs are a type of second mortgage. 

• HELOCs are secured loans. You’ll pledge your home as security that you'll pay back the loan (this is commonly called “using your home as collateral”). Secured loans are lower-risk to the lender, so interest rates are typically lower on HELOCs compared to unsecured loans (like credit cards).

• Most HELOCs have a minimum and maximum amount of money you can borrow. Every lender is different, but the minimum might be around $15,000. The maximum will be based on the lower of two amounts. First, a maximum dollar figure set by a lender. Second, a percentage of your home’s value, usually around 80%. 

• All HELOCs have a draw period and a repayment period. During the draw period, usually 5 to 10 years, you can borrow and repay as you like, up to your credit limit. When the repayment period begins, you can’t borrow more. The repayment period is generally 10 to 20 years.

Now, here are the differences between the various kinds of HELOC:

Traditional HELOC

A traditional HELOC has a variable interest rate. That means that the rate can and usually does go up and down, depending on the overall market. Some HELOCs are offered at low teaser rates and then increase to a higher variable rate. Most traditional HELOCs can be converted to a fixed-rate loan when the repayment period starts.

Once you have a traditional HELOC, you might only need to make interest payments during your draw period. After the draw period ends, you’ll need to make regular monthly principal and interest payments. This means your payment amount might rise sharply. Also, some HELOC payments aren’t calculated to repay the loan by the end of the repayment period. In that case, there would eventually be a balloon payment due. A balloon payment is a single and often very large payment to pay off the remaining outstanding balance. 

Hybrid HELOC

Some people use “hybrid HELOC” and “fixed-rate HELOC” interchangeably, but they aren't the same. A hybrid HELOC allows you to lock in your interest rate at different times. You may need to draw your full loan amount at a fixed interest rate at the beginning of your HELOC. As you pay it down, you can borrow more until your draw period ends, but the rate on those withdrawals would be based on whatever current rates are. The number of times you can lock a rate is usually limited to between two and five.

Fixed-Rate HELOC 

A fixed-rate HELOC is the newest type of HELOC. Unlike other types of HELOCs, it allows you to lock your interest rate on day one. You still get the flexibility of a draw period, but you'll only pay interest on the amount you borrow. You can borrow part or all of the total loan limit, pay it back, then borrow again as you like during the draw period. Your monthly payments during the draw period are principal and interest payments based on your statement balance. 

After the draw period, the repayment period starts. Your monthly payment will be fixed at an amount that'll pay off the loan by the end of the repayment period.  

What is a cash-out refinance?

A cash-out refinance is when you replace your current mortgage with a new mortgage that’s larger than your existing one. Your first mortgage is paid off, and you receive the difference in cash (minus any closing costs), which can be used for any purpose. 

Cash-out refinancing makes sense when current mortgage rates are lower than the rate on your existing mortgage. 

How is a cash-out refinance similar to a fixed-rate HELOC?

Both fixed-rate HELOCs and cash-out refinances are types of mortgage loans. Because they are secured by your home, the interest rates for both fixed-rate HELOCs and cash-out refinancing tend to be lower than other ways to borrow money, such as using credit cards.

Also, both a HELOC and a cash-out refinance are likely to have a higher loan limit than personal loans. 

How is a cash-out refinance different from a fixed-rate HELOC?

There are four major differences between a fixed-rate HELOC and a cash-out refinance. 

1) Different loan types.

• A cash-out refinance replaces your current mortgage with a newer, larger one. 

• A fixed-rate HELOC is a separate loan.

2) The amount of money you borrow can vary widely.

• For a cash-out refinance, you’ll have to make a decision up front about the full amount of money you need. 

• For a fixed-rate HELOC, you can take out only the amount that you need, as you need it. If you don’t need to borrow your maximum loan amount, you don’t have to.

3) Different monthly payment options

• With a cash-out refinance, you’ll have one mortgage payment that includes your existing loan amount plus the new amount you’ve borrowed. You'll immediately begin paying a principal and interest payment against your full borrowed amount.

• With a traditional HELOC, you’ll make a separate loan payment in addition to your mortgage. You might only have to make interest payments during the draw period. This means that although you’ll be making payments for several years, you won’t make any headway against your balance. Also, your payment will spike when the repayment period begins.

• With a fixed-rate HELOC, you’ll make a separate loan payment in addition to your mortgage. Your payment during the draw period will be based on your statement balance, but it'll be a principal and interest payment, not interest-only. 

4) Different qualification guidelines

• For a cash-out refinance, most lenders require a credit score of at least 620, sometimes much higher.

• For a fixed-rate HELOC, you can apply with a credit score of at least 640 (if you’re using the money to pay off other creditors).

When is a fixed-rate HELOC better than a cash-out refinance?

Here are some situations when a fixed-rate HELOC is generally a better choice than a cash-out refinance:  

• When you have a great mortgage interest rate. If you have a low existing mortgage rate, you probably don’t want to give that up. A cash-out refinance interest rate replaces your original rate, and could be higher than your existing mortgage interest rate.

• If you don’t want a new 30-year mortgage. You may have been paying your mortgage for years. A cash-out refinance typically starts you over on a new 30-year mortgage loan unless you ask for a shorter term. 

It’s important to note that in the past, a traditional HELOC’s variable interest rate would often be a major disadvantage for borrowers. However, a fixed-rate HELOC removes that drawback.