Home Equity Loan or HELOC vs. Cash-Out Refinance: Ways to Tap Your Home’s Value

A home equity loan, a home equity line of credit and a cash-out refinance are all ways to access the value that has accumulated in your home. Here are points to consider when deciding which might be best for you.

Hal M. Bundrick, CFP, Kate WoodSeptember 22, 2020
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Home Equity Loan or HELOC vs. Cash-Out Refinance: Ways to Tap Your Home's Value

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Home equity loans, home equity lines of credit (HELOC) and cash-out refinances are three ways to turn your home's value into funds you can use to accomplish other goals, like paying for home improvements or consolidating debt.

You get the cash by borrowing against your home equity, which is the difference between the current value of your home and the amount left to pay on your mortgage.

Although these loans are similar, they’re not the same. If you already have a mortgage, a home equity loan or a HELOC will be a second payment to make, while a cash-out refinance replaces your current mortgage with a new one — complete with its own term, interest rate and monthly payment.

If you're thinking about tapping into your home equity, here's what you should know.

Start by checking your home equity

Your home equity comes from paying down your home loan and can also increase from property appreciation. Selling your house is, of course, one way to convert that equity into cash. But if you're looking to tap into those funds without selling, you have to borrow against the equity with a home equity loan, line of credit or cash-out refinance.

Of course, you need to have an ample amount of home equity first.

To figure out how much home equity you have, estimate your home's value and find out how much you still owe on the mortgage. If the difference between the two is a positive number, that’s the equity you have in the home. But if you owe more than your home is worth, you're not a candidate for a cash-out refinance, home equity loan or HELOC.

How much equity do you have?

Your home equity can help you pay for improvements. NerdWallet can show you how much is available.

Home equity loans and HELOCs vs. cash-out refinances: Understanding your options

Qualifications will vary by lender, but if you have at least 15% home equity, you may be a candidate for one of these loans. Here are the basics of each:

Home equity loans

A home equity loan lets you borrow a lump sum that you then pay back at a fixed rate. It's technically a second mortgage, so you'll make payments on it in addition to your regular monthly mortgage payments. (One exception: If your house is paid off and you take out a home equity loan, it would be considered your primary mortgage.)

Home equity line of credit (HELOC)

A home equity line of credit is also a second mortgage that requires an additional monthly payment. But instead of getting the cash all at once, you can borrow as needed during the draw period. You then repay what you borrowed plus interest during the repayment period. Unlike home equity loans, HELOCs usually come with an adjustable rate, so your monthly payments will vary.

Cash-out refinance

A cash-out refinance replaces your original mortgage with an entirely new loan that's greater than what you currently owe. The difference between the current loan amount and the new loan amount provides the "cash out." And though rates for cash-out refinances are generally higher than for rate and term refinances, your interest rate will still probably be lower than a home equity loan or HELOC rate.

How home equity loans, HELOCs and cash-out refinances are similar

  • You’ll typically need an after-transaction loan-to-value ratio of 90% or less to qualify for any of them.

  • You can use the money as you see fit, though it’s generally recommended that homeowners only borrow against home equity for value-adding home improvements or debt consolidation.

  • Your home is the collateral, so failure to make payments could lead to foreclosure.

How home equity loans and HELOCs are different from cash-out refinances

  • Interest rates are generally lower for cash-out refinances than for home equity loans or HELOCs.

  • Closing costs are generally higher for cash-out refinances, since a refinance is essentially a brand new mortgage. Closing costs for home equity loans and HELOCs are typically lower.

  • A cash-out refi results in one, bigger loan, while a home equity loan or line of credit is a loan in addition to your first mortgage.

FAQ comparing home equity loans, HELOCs and cash-out refinances

Is it better to get a second mortgage or refinance?

If you're weighing a second mortgage in the form of a home equity loan or HELOC against a cash-out refinance, here are a few things you can consider.

Current mortgage rates: If refinancing could get you a lower rate and you intend to stay in the home long enough to hit your break-even point, then a cash-out refi may make more sense than a second mortgage.

How much you want to borrow: Borrowing a relatively small amount of money? A home equity loan may be a better option since you won't have to pay hefty refinance closing costs but you'll still receive the funds as a lump sum. Home equity loans and HELOCs do come with closing costs, so if you're only looking for a little liquidity, a low-interest credit card or a small personal loan might be enough.

Your plans for the money: If you're not sure exactly how much you'll need to borrow, or your renovation might unfold over a long period of time, a HELOC may be your best choice. But if your improvement plans are vague, using your house as collateral for a HELOC is a risky proposition.

How long you'll live in the house: If you intend to relocate within a relatively short timespan, a home equity loan might make more sense than refinancing or getting a HELOC. A cash-out refinance might have a lower interest rate, but it'll take several years to recoup the closing costs you’ll pay upfront. HELOCs also tend to have a long lifespan — 10 years for the draw period, and 20 years for repayment. But if you sell your home before you've finished paying back the HELOC, you'll have to pay the balance as a lump sum.

Which is easiest to qualify for?

A cash-out refi will usually be a bit easier to qualify for than a HELOC or home equity loan. It is replacing your primary mortgage; lenders like that because it gives them "first position" as a creditor.

A cash-out refi will usually be a bit easier to qualify for.

Home equity loans and HELOCs are “second mortgages.” Aside from being an additional mortgage on top of your original home loan, it also means the new loan or line of credit is second in line when it comes to payback priority.

Whether you decide on a HELOC, a home equity loan or a cash-out refinance, shop around to get the best rate and terms. You don't have to go to your current mortgage lender, though you may want to ask for a quote.

Nerd tip: Comparison shopping for home equity loans or cash-out refinances may be harder right now, as some lenders have stopped offering these loans due to economic concerns.

How much can you borrow?

With a home equity loan, a HELOC or a cash-out refinance, the amount you can borrow will depend on several variables. The amount of home equity you have, your credit score, your debt-to-income ratio and the loan-to-value ratio all play a role in determining how much a lender will let you borrow and at what rate.

Also, you can't borrow the full value of your home. Expect your all-in loan debt to be no more than 90% of your home’s value.

When do you have to pay it back?

Cash-out refis can extend to 30 years, just like a primary mortgage. When refinancing to get cash out, you can choose to keep your original term, go to a shorter term or extend the length of your term. Your monthly payments may increase with a cash-out refinance, especially if the new loan has a shorter term or is for a much larger amount than your original mortgage.

With a HELOC, payments aren't typically required during the draw period. The length of the draw period can vary, but 10 years is pretty common. During the draw period, you might have the option to make monthly payments against the interest. Once you're in the repayment period of a HELOC, you'll make payments against both the principal and the interest. The repayment period on a HELOC is longer than the draw period; 20 years is fairly standard (so combined with the draw period, it’s a 30-year loan).

Home equity loans are generally shorter, with repayment periods no longer than 15 years. Keeping the term short — while making sure you can afford the payments — lowers the total amount of interest you'll pay.

Are the proceeds taxable?

Home equity is a type of profit (in tax jargon, it’s called a "capital gain") that you realize only when you sell your house. So the money you get from a cash-out refinance, HELOC or a home equity loan isn't taxable because it’s borrowed money you have to pay back.

Is the interest paid tax-deductible?

Interest paid on home equity loans and HELOCs should be tax-deductible so long as the funds you borrowed are used for home improvements. According to the IRS, the proceeds must be used to “buy, build or substantially improve the taxpayer’s home that secures the loan.”

A cash-out refinance is treated like any first-lien mortgage. If you itemize deductions for the 2020 tax year, you can deduct interest paid on the first $750,000 of the mortgage.

To dig into the details on either scenario, talk to a trusted tax advisor.

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