Both a cash-out refinance and a home equity line of credit (HELOC) are refinancing options for homeowners looking to tap their property’s equity. Through a cash-out refinance, the homeowner receives a check for the difference between the original mortgage and the home’s equity by applying for a new, larger mortgage. A HELOC, on the other hand, acts as a revolving line of credit that the homeowner can access as needed.
As the real estate market rises, many homeowners may find that their home’s value has risen significantly. With this rise in value comes a rise in equity, leaving some homeowners house-rich and cash-poor.
Homeowners can tap into this equity appreciation and quickly access cash through two refinancing options: a cash-out refinance or a home equity line of credit.
While both options allow you to access your home’s equity, there are several key differences that may make one a better option for you. Keep reading to learn more about cash-out refinances and HELOCs, the differences between the two, and how to know which is right for you.
What does it mean to refinance a mortgage?
Refinancing a mortgage is essentially taking out a new mortgage with different terms. Homeowners may refinance if their credit scores improved, resulting in a better interest rate, lower monthly payments, or a short term. However, you may also want to refinance your mortgage if you’ve built up equity in your home.
Let’s say you have an existing mortgage for $500,000. If you bought your house a year ago and prices remained stable, you might say: “I can lower my monthly payment for my mortgage if I refinance at a lower rate.” You speak with a qualified mortgage professional or visit your local bank and discover you could refinance your 5% mortgage at 3%.
You are not taking out additional cash but replacing your primary mortgage with another first mortgage at a lower rate. Though you’ll have to pay points and other fees, you could save money in the long run on interest fees.
Do you lose equity when refinancing a home?
It depends on how you do it. If you don’t take on additional debt, you shouldn’t lose any equity. However, a longer-term could mean you pay more interest over the life of the loan. But if you get a cash-out refinance mortgage, you will be converting some of your equity into cash.
What does cash-out refinance mean?
A cash-out refinance replaces your first mortgage with a larger loan. While it may sound counterintuitive to get a bigger loan, part of that loan takes a portion of your equity and converts it into cash for you.
When you refinance your home through a cash-out refinance, you take on a larger mortgage based on the appreciated value of your property. This doesn’t mean you extend the term of the mortgage. However, because this is a type of mortgage refinancing, cash-out refinances allow you to extend the term on your home loan.
Here is a list of the benefits and the drawbacks to consider.
- Tap your equity. When you replace your mortgage with a larger loan, you’ll get a check for additional cash that comes directly from the equity in your home.
- Single payment. Since you swap one mortgage for another, the cash-out refinance mortgage lets you stick with one monthly mortgage payment.
- No capital gains. Because the cash you receive from a cash-out refinance comes from a loan, the money is not subjected to capital gains taxes.
- Interest rate. Depending on your current mortgage interest rate, a cash-out refinance may even allow you to access a lower interest rate. The interest rate is also often a fixed rate.
- Loan application process. Mortgage loan applications can be long and complicated, and unfortunately you’ll have to do this again with a cash-out refinance.
- Additional expenses. Cash-out refinances often result in a number of additional expenses to the borrower through higher interest rates and points. Since this is also a new loan, you’ll have to pay closing costs as well.
- Good financial position. To receive a more favorable refinance deal, you need a great credit score and a reasonable debt-to-income ratio (DTI), which should be around 50% or lower. A better credit score and DTI may reduce the additional expenses you’ll need to pay.
- Monthly payments may increase. Lenders often consider cash-out refinances to be riskier than other refinancing options, which may result in a higher interest rate. In addition to interest, the larger mortgage you take out will result in higher monthly mortgage payments.
- Possibility of PMI. If the equity in your home decreases below 20%, your lender may require you to get private mortgage insurance.
What’s a home equity line of credit?
A home equity line of credit (HELOC) is a second mortgage on your home that allows you to pull equity from your home as a line of credit. (Think of it as a credit card that is secured by your home.)
Since this refinancing option is a revolving line of credit, you can continue to pull money until the draw period ends or until you reach the credit limit. During the draw period, you are typically only required to pay the interest on your line of credit. However, once the draw period ends, you will need to make payments on the interest and principal owed. The good news is the rates of interest for HELOCs are lower than credit card interest rates because the loan is secured by real estate.
HELOCs often live in two time periods. The first is a ten-year draw period where you access the line of credit for the projects you have in mind and make interest-only payments along the way. The second is the repayment period, where your ability to draw funds stops and you enter into a 10- to 20-year period when you make regular payments of both principal and interest.
Here is a list of the benefits and the drawbacks to consider.
- Quicker approval process. Unlike a cash-out refinance that creates a new mortgage, the HELOC doesn’t require the long time period of the standard mortgage approval process. This means that HELOC loans are generally approved quicker than traditional mortgages or cash-out refinances.
- Access as needed. Unlike other refinance options, a HELOC allows you to access cash as you need it during the draw period. This means you don’t pay interest on the money you don’t use.
- Limited additional expenses. While a credit check is still required, there are usually fewer closing costs associated with a HELOC.
- Variable interest rate. Unlike a cash-out refinance, the interest for a HELOC is usually variable, meaning the interest can change. This could be a cause for concern in a rising interest rate environment.
- Too easily accessed. It’s easy to be reckless when the line of credit can be accessed via checkbook or a debit card. And because this credit line is secured by your home, you have access to a large amount of credit that could sink you into debt.
- Credit requirements. Even though a HELOC is secured by your home, lenders’ credit requirements can be more stringent because the interest rate over time is unknown.
- Not always tax-deductible. There are restrictions on what funds can be used for when considering if the interest is tax-deductible. Generally, it is for home improvements, although you can use funds for other purposes if tax deductibility is not a major concern.
How is a HELOC different from a home equity loan?
Home equity loans and HELOCs are similar in concept, as both offer homeowners additional funds by tapping equity. However, home equity loans and HELOCs differ largely in how the funds are accessed.
A home equity loan is more similar to a loan, where the borrower takes out a second mortgage secured by the additional untapped equity in your house. However, a home equity loan provides these equity funds in one lump sum rather than through a line of credit. Rather than accessing the funds as you need them, you must pay back the entire home equity loan with interest (which is usually at a fixed rate) in a set repayment period.
Cash-out refinance vs. HELOC: Which is better for you?
One of the great features of the mortgage business is the flexibility of the solutions available. Depending on your needs and individual situation, you’ll likely find a refinancing solution that differs widely from another homeowner.
Because of the differences between the below options, consider your individual situation before applying for either a cash-out refinance or HELOC.
A cash-out refinance is best for a borrower who has a fixed goal in mind. This may be a home renovation, construction for an addition to your property, or even purchasing another property.
Because this refinancing option provides a lump sum, a borrower should know approximately how much repairs or renovations will cost before applying for a cash-out refinance.
Since a HELOC offers a revolving line of credit, borrowers looking into this option don’t necessarily need a strict plan in mind.
Perhaps your child is entering college and you need to access extra money to make tuition payments. You’ll need access to cash, but not all at once. With a HELOC, you can draw money as needed without making payments on the principal until after the initial draw period closes.
HELOCs also have flexibility. Suppose college isn’t the right option for your child, and you no longer have to worry about tuition bills. Since you don’t need extra cash anymore, you don’t need to access your line of credit.
|How are funds received?||In one lump sum||As a line of credit to use as you need|
|Interest rate?||Fixed interest rate||Variable interest rate|
|Extra fees?||Closing costs and points||Closing costs|
|Approval process?||Same as a home loan:|
• Credit check
• Review of DTI and income
• Home appraisal
• Underwriter approval
|Fixed monthly payments?||Yes||No|
What option is better for rising interest rates?
Depending on the interest rate environment, a HELOC may not be your best choice for tapping your home’s equity. If you find yourself in this situation, you have a few options.
- Switch for a home equity loan. You could replace their HELOC with a home equity loan at a fixed interest rate. The rate might not be the most attractive because the lender is taking the position of the second mortgage holder. However, if mortgage interest rates are expected to continue rising, locking in a fixed interest rate may be best.
- Pay off your HELOC with a cash-out refinance. If you already have a HELOC, you may still be able to apply for cash-out refinancing (provided your home has the equity to spare). The additional money freed up could pay off the HELOC, rolling two loan products into one mortgage with a fixed interest rate.
What are the tax consequences?
Home mortgage interest is generally deductible on your personal tax return, up to certain limitations. This means that any funds you use to purchase, build, or remodel your property can be tax-deductible.
For cash-out refinances, this could mean that the interest from the loan is tax-deductible, provided you use the funds to permanently improve the property. Any interest on the purchases made using a HELOC is also considered deductible provided the funds are used for improvements to your property.
However, this tax benefit is not available for borrowers using these funds for other purposes. Due to this slippery slope, you may be better off consulting a qualified tax professional before refinancing your home.
Do I have to pay taxes on a cash-out refinance?
No, you do not need to pay taxes on a cash-out refinance. Technically, the money you get from a cash-out refinance is not income but a loan.
- The range of mortgage products is very flexible. If you are a homeowner who needs additional cash, there are products that can help you get access to untapped equity in your home.
- Cash-out refinancing involves taking out a larger mortgage loan that allows you to access your home’s equity.
- The money you get from a cash-out refinance or a HELOC is not subject to income tax because you are taking out a loan.
- HELOCs have the flexibility of borrowing when you need the funds instead of receiving a lump sum and paying interest on the loan, even when you aren’t using the funds.
- Depending on how you use the funds from your HELOC or cash-out, the additional interest from refinancing may be tax-deductible.
View Article Sources
- Timeshares, Vacation Clubs, and Related Scams — Federal Trade Commission: Consumer Advice
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- Home Equity Loan vs. Line of Credit: Which Should You Choose? — SuperMoney
- How To Get Equity Out Of Your Home — SuperMoney
- The Definitive Guide to Cash-Out Refinancing — SuperMoney
- Reverse Mortgage vs. Home Equity Loan vs. HELOC: Pros & Cons — SuperMoney
- The Best Shared Equity Alternatives to a Cash-Out Mortgage Refinance | April 2022 — SuperMoney
- Refinancing a Mortgage? Here’s What You Need To Know — SuperMoney
Bryce Sanders is president of Perceptive Business Solutions Inc. He provides HNW client acquisition training for the financial services industry. His book, “Captivating the Wealthy Investor” is available on Amazon. Bryce spent twenty years with a major financial services firm as a successful financial advisor. He has been published in 40+ metro market editions of American City Business Journals, Accountingweb, NAIFA’s Advisor Today, The Register, LifeHealthPro, Round the Table, the Financial Times site Financial Advisor IQ and Horsesmouth.com.