Cash Out Refinance vs HELOC

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When homeowners require additional funds, they frequently tap into their home’s equity through home equity loans or lines of credit (HELOC). Let's compare the options of cash-out refinance and HELOC.

Cash-Out Refinance vs. HELOC

A HELOC enables you to borrow against your home's equity, providing access to cash as needed.

How Does a HELOC Work?

A HELOC is a line of credit secured by your home’s equity. It functions as an interest-only loan during a specified draw period, which is often around ten years. Lenders typically allow borrowing up to 80% or 90% of your home’s equity.

The HELOC has two phases: the draw period, during which you only pay interest on the amount you use, and the repayment period, when you start paying both principal and interest.

During the draw period, you can access funds up to your approved limit and only incur interest on the amount you actually borrow. After this period, you will make monthly payments that include both principal and interest on the remaining balance until the loan is paid off.

HELOCs generally have variable interest rates tied to the prime rate, which means your interest rate can change based on market conditions and potentially increase over time.

How Does a Cash-Out Refinance Work?

A cash-out refinance involves taking out a new mortgage to replace your existing one. With today's low-interest rates, refinancing can provide additional cash while securing better mortgage terms.

For example, if your home is valued at $400,000 and you owe $200,000, you have $200,000 in home equity. Many lenders will let you borrow up to 80% of your home's value, which in this case would be $320,000, leaving you with $80,000 in cash.

How Does a HELOC Compare to a Cash-Out Refinance?

A cash-out refinance lets you benefit from fixed, low-interest rates throughout the life of the new mortgage, though it may not always offer the absolute lowest rates.

In contrast, HELOCs and home equity loans are second mortgages. If you default, these loans are repaid only after the first mortgage is settled. Consequently, if the home sale does not cover the second mortgage, you remain responsible for any remaining balance.

When Should You Choose a HELOC?

A HELOC might be the ideal choice if you plan to use the cash gradually over time. It provides flexibility, allowing you to withdraw funds as needed or not at all, and you only pay interest on the amount you use. This makes it a good safety net in situations like job loss. If you don’t draw on the line of credit, you won’t incur any interest charges.

Lenders typically offer competitive rates ranging from 2.49% to 21%, depending on your credit profile. Consulting with a mortgage banker can help you explore all available options.

HELOC Requirements

To qualify for a HELOC, you generally need to have 15% to 20% equity in your home. An independent appraisal will be required to determine this equity.

Additionally, you need a debt-to-income (DTI) ratio between 43% and 50%. This ratio is calculated by dividing your monthly debt payments by your gross income. Some lenders may include expenses like utilities and transportation in this calculation, while others may not. It’s crucial to borrow within your means to ensure you can comfortably repay the loan.

A good credit score and a solid history of timely bill payments are also necessary.

When Does a Cash-Out Refinance Make Sense?

A cash-out refinance can be beneficial if you want to convert your home’s equity into cash while securing a lower interest rate on your mortgage. Given the current economic climate with rising home values and historically low interest rates, this could be an opportune time to refinance.

Cash-out refinance rates are typically slightly higher than those for standard refinances. The rate you receive will depend on the amount of cash you wish to withdraw and your credit score.

Check with your bank for the current cash-out refinance rates, which usually range from 0.125% to 0.5% above standard refinance rates. This method is often one of the lowest-cost borrowing options for significant expenses.

A cash-out refinance is suitable for home remodeling, paying taxes, settling an existing HELOC, consolidating debt, or financing education.

Cash-Out Refinance Requirements

The interest rate for a cash-out refinance is influenced by your equity, credit score, and the loan amount. Higher cash-out amounts generally lead to higher interest rates.

Your home will need to be appraised by an independent appraiser. For the new loan, you’ll need a DTI ratio of 43% or less, an LTV ratio of 80% or lower, and a minimum credit score of 620.

Conclusion

Choosing between a cash-out refinance and a HELOC depends on your needs, timing, and how long you plan to stay in your home. Consider additional costs like application fees and mortgage insurance, and budget accordingly. Our mortgage team is available to answer your questions and help you explore your options.