When homeowners need extra cash, they often borrow against the equity in their home, known as home equity loans or lines of credit (HELOC). Let’s explore the options of cash-out refinance vs. HELOC.
Cash Out Refinance vs HELOC
A HELOC allows you to borrow against the equity in your home to draw out cash when you need it.
How Does a HELOC Work?
A HELOC is a line of credit guaranteed by the equity in your home. HELOCs are interest-only loans taken out over a specific period, for example, ten years. Most lenders will allow you to borrow up to 80% or 90% of the equity in your home.
There are two parts to a HELOC loan, the draw-down period in which you pay interest only and the second part after the term of the loan expires, at which point you pay principal and interest.
During the term of a HELOC loan, you’re able to withdraw the money as and when you need it up to the approved limit of the loan, known as the loan’s drawdown period. You only pay interest on the amount you withdraw, not the total amount you’ve been approved for. After the drawdown period ends, you then pay a combined principal and interest payment on the amount you drew down until the loan is fully repaid.
HELOCs typically incur an adjustable interest rate based on the prime rate which meansinterest rates can fluctuate depending on market conditions and potentially rise over time.
How Does a Cash-Out Refinance Work?
Refinancing means you open a new mortgage to pay off your existing mortgage. With current low-interest rates, refinancing your home can allow you to access additional cash plus obtain a better mortgage rate and terms.
Let’s say your home is worth $400,000, and you owe $200,000. This means you have $200,000 equity in your home. In this scenario, many lenders will allow you to borrow up to 80% of the home’s value, which would be $320,000, leaving you with $80,000 in cash.
How Does a HELOC Work vs Refinance to Pull Out Cash?
A cash out-refinance option allows you to take advantage of fixed, low-interest rates for the life of the mortgage. Keep in mind; a fixed-term mortgage may not offer you the lowest of the lowest interest rates.
HELOC and home equity loans are considered second mortgages. If homeowners default, these loans only get paid back after the first mortgage is paid. In the event of a shortfall, homeowners are still liable for the remaining balance of the second mortgage.
When Should You Choose a HELOC?
If you intend to use the cash over a period of time, a HELOC may be your best option. This option allows you to withdraw the cash as and when you need it or not use it at all. A HELOC is often used as a backup strategy for example if you lose your job. If you don’t use the money, you don’t pay interest.
Most lenders offer competitive rates that range from 2.49% to 21%, depending on creditworthiness. A mortgage banker can walk you through all of your options.
To qualify for a HELOC loan, you will need to have at least 15% – 20% equity built up in your home. The lender will require an independent appraisal to assess the equity value in the home.
Secondly, you need a debt-to-income (DTI) ratio that sits somewhere between 43% and 50%. Lenders will calculate the DTI ratio by calculating your monthly debt obligations by your pre-tax or gross income. Some lenders may not consider monthly expenses such as utilities, food, and transportation costs while others do. It’s important not to overextend yourself and borrow more than you are comfortable repaying back.
Thirdly, you need a qualifying credit score, along with a strong history of paying your bills on time.
When Does a Cash-Out Refinance Make Sense?
A cash-out refinance option offers two big benefits. It allows you to turn your home’s equity into cash plus lock in a lower interest rate on your mortgage. With current economic conditions, home values are increasing exponentially and interest rates are near all-time lows. If you were considering refinancing your home to access cash, there is probably no better time than now.
Cash-out refinance rates are usually slightly higher than a traditional refinance rate. The rate you receive depends on how much cash you want to take out and your credit score.
Talk to your bank to find out current cash-out refinance rates. Typically rates can be anywhere from 0.125% to 0.5% higher than rates you find for a no-cash out refinance mortgage. If needing to finance more considerable expenses, this is one of the lowest-interest forms of borrowing.
A cash-out refinance option makes sense if you plan on remodeling your home, need to pay income tax, pay off an existing home equity line of credit, for debt consolidation or college education.
Cash-Out Refinance Requirements
The rate depends on your personal circumstances and the equity in your home. The rate will be based on the loan-to-value (LTV) ratio along with your credit score, and the value of the loan. The more equity you cash out, the higher the interest rate.
The value of your home will need to be appraised by an independent appraiser. The new loan’s DTI ratio needs to be 43% or less, a LTV ratio of 80% or less, and a credit score of at least 620.
Whether you choose a cash-out refinance vs. HELOC, consider why you need the cash, when you need the cash (now or later), and how long you plan on staying in your home. Make sure you factor in other costs such as application fees, mortgage insurance, and any other applicable fees and budget accordingly. Our mortgage team is here to answer any questions you have and to walk you through your options.