Tapping Home Equity Cash-Out Refinance Home Equity Loan

Both a home equity line of credit (HELOC) and a cash-out refinance let you tap into your home’s equity and turn it into cash.

But they are very different products. Which one you choose depends on your situation.

Here’s how to decide.

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Quick rules of thumb:

Get a cash-out refinance if you have a lot of home equity and want a large lump sum upfront, and don’t mind replacing your first mortgage.

Get a HELOC if you want to keep your first mortgage intact and want low closing costs and an easier process. These allow work well if you have little equity in your home.

When to get a cash out refinance

You plan to take out a very large sum: A cash-out refinance is best when you’re taking a lot of cash – north of $100,000 to $200,000. That’s because these loans come with high closing costs. Paying $5,000 in costs to access $20,000 is not a good idea.

You have a lot of equity: See above. If you’re not accessing a very large sum, the cost of a cash-out refinance is too high. You can only tap up to 80% of your home’s current value. You need at least 30-40% equity in the home to make this loan worth it. That will give you the ability to tap 10-20% of your home’s value.

Rates are lower than when you opened your original loan: This probably isn’t the case in 2022 or 2023 because mortgage rates have doubled since early 2022. However, if you have a very high rate on your existing first mortgage, you might be able to lower your rate and access cash at the same time. In this case, you might choose a cash-out refinance even if you are not getting a large sum of money at closing.

You want a fixed rate: Most cash-out refinances are 30-year fixed rate mortgages. HELOCs, though, come with variable rates. If you like the idea of a fixed rate and payment, opt for a cash-out refinance. However, keep in mind that you could also get a home equity loan, which is a fixed-rate second mortgage. Many HELOC lenders also allow you to lock in your HELOC rate after closing.

How a cash-out refinance works

A cash-out refinance replaces your existing loan with a larger loan. You take the difference in cash at closing. You end up with one loan on the property.

When to get a HELOC

You have a very low first mortgage rate: A HELOC doesn’t affect your first mortgage. You can access home equity without touching that low rate.

You want to close fast: Many HELOC lenders don’t require much documentation to close. A few paystubs and signatures may be all you need. This speeds up the approval and closing process.

You don’t want to pay high closing costs or get an appraisal: This is where HELOCs really shine. Some lenders offer zero-closing-cost HELOCs. Accessing the funds is inexpensive and easy.

You don’t have much home equity: Some lenders allow you to access up to 100% of your home’s equity. If you already have a first mortgage equal to 80% of your home’s value, a cash-out refinance isn’t even an option. But, you may be eligible for a HELOC.

You don’t mind a variable rate: HELOCs are typically based on the current prime rate. So your HELOC rate will be expressed as “prime + 0.5%” or “prime – 0.25%” for instance. The prime rate can rise and fall depending on what’s happening in the economy. Check today’s prime rate and make sure you’re comfortable paying, for instance, prime + 0.50%, even if prime rises by 2% or 3% from current levels.

You want to draw and repay funds as needed: A HELOC is like a credit card in that you can use and repay funds as much as you want. The “draw period”, as it’s called, usually last 10 years. Then, the existing balance typically converts to a 15- or 20-year term where you start paying it off and can’t draw additional funds. 

You don’t need the money right away: Many lenders allow you to open a HELOC without taking an initial draw of funds. That means you could have access to a large sum of money and pay zero interest until you draw from the HELOC.

How a HELOC works

A HELOC is a new, separate loan added on top of your primary mortgage. It does not affect your first mortgage rate or terms. HELOCs come with very low closing costs compared to cash-out refinances, and often don’t require an appraisal.

HELOC vs. cash-out payment examples

This scenario assumes a homeowner with a home worth $400,000 and a current first mortgage balance of $200,000. The homeowner needs $100,000 in cash.

HELOC vs Cash-out

At first glance, it appears the HELOC option is better. But keep in mind that the HELOC payment is interest-only, and no principal is being paid. The cash-out refinance balance is being paid down each month.

Now let’s see what happens if the HELOC rate rises by 2%, which is realistic in today’s rising-rate environment.

What if the HELOC rate rises?

HELOC converts to a fully-amortizing payment

After 10 years, the HELOC becomes a fully-amortized loan on a 15- or 20- year term, typically. What happens to the overall payment at an 8% principal + interest payment HELOC?

Even with the fully-amortized payment, the HELOC still seems like a better deal. However, keep in mind that the rate is variable and could even rise above 8% or 10%. Verify your maximum possible rate before accepting a HELOC.

*Note that all rates and payments mentioned are for example purposes only. Apply for a HELOC and cash-out loan for personalized rates.

Tax deductibility

Both a HELOC and the cash received from a cash-out refinance have tight regulations around tax deductibility. For both to be tax deductible, you have to use the funds to buy, build, or significantly improve your primary residence. Keep receipts for home improvements and other qualifying projects so you can deduct interest on the funds used.

Should you get a HELOC or cash out refinance?

There’s no single right answer. Each person’s situation will play into the decision. Get quotes for both a HELOC and a cash-out refinance, then see which payment is lower and which one will suit you the best long-term.