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By Jamie Smith
Learn about the benefits of HELOCs versus cash-out refinances. Consider how a HELOC can allow you to use the equity in your home for various financial needs.
Sometimes life demands more money than you have in your savings account, and you have to get creative. Putting bills and significant expenses on your credit card is risky; many cards have double-digit interest rates and harsh penalties for late payments. Other loans can only be used for certain expenses, such as loans for cars or loans for college. But if you own a home — and you have home equity — you have options. Explore your options for a HELOC versus a cash-out refinance.
Think of your home as a savings account. Every time you make a monthly mortgage payment, a portion of the payment goes to covering interest on the loan, but part of the payment also goes to the principal. The principal portion of the payment turns into equity in your home. All of these mortgage payments, and the growth of your home's property value over time, are stored-up money. You can determine the equity in your home with this simple formula:
Home equity = (the property's value) - (remaining mortgage balance)
Traditionally, you wouldn't be able to access this equity unless you sold your home. But many homeowners who have equity in their home have two popular options available to them: a home equity line of credit (HELOC) and a cash-out mortgage refinance.
A HELOC operates more like a credit card than a loan. You receive approval for a certain amount, usually about 90% of your home equity amount. Instead of accepting this amount in a single lump sum, it's a line of credit you have access to throughout the draw period, usually about 7-10 years. You can draw a portion or all of the funds at any point, replenish them and draw from them again.
These funds, minus the amount you've withdrawn, stay available throughout the draw period. You repay any money you withdrew during the repayment period.
A cash-out refinance loan replaces your current mortgage with a new mortgage arrangement. When applying for a cash-out refinance, your lender approves how much you can withdraw, your new mortgage term and a new mortgage interest rate. You can pull out the majority of the equity in your home, but you can't pull out all of it. Many lenders require you to keep at least 20% of your equity locked in the property to mitigate risk.
Consider this scenario: You have a house valued at $400,000, and you have a remaining mortgage of $100,000. Under this scenario, you have $300,000 equity in your home. With a cash-out refinance, you may be able to reset your mortgage to a $320,000 mortgage, which leaves $80,000 of equity in the house and lets you pull out $220,000, minus closing costs and fees, as a lump sum.
Both options use your home equity as leverage to give you access to additional funds. While the mechanisms and distinctive advantages of either approach are essential, you want to know the attributes they both share. Either option can be a good fit for these scenarios:
You want funds to cover home improvement projects, college tuition or other expenses
HELOCs and cash-out refinances allow you to decide what you want to do with your money. You can use the funds to finance a home renovation or buy a new car.
Both options allow you to demonstrate your consistent payment habits. If you consistently pay down your mortgage or HELOC on time, this consistency can positively affect your credit over time. You're demonstrating to future potential lenders that you're a low-risk option.
A cash-out refinance is ultimately replacing your old mortgage with a new one. The interest payments may be tax-deductible if you itemize your deductions. Similarly, you can think about a HELOC as a type of mortgage. As a result, the interest payments may be tax-deductible, although you'll want to check with your accountant to be sure.*
Despite these similarities, both options have particular advantages. Sometimes a HELOC is a perfect fit, and sometimes a cash-out refinance is the right solution. Consider these common scenarios to see which one you should consider.
In general, HELOC applications and approval processes move faster than cash-out refinances. You can be quickly approved because the process is less involved and strenuous. A cash-out refinance process is more like applying for a mortgage, sometimes involving appraisals and title reviews, negotiations and closing costs.
One of the key differences between a HELOC arrangement and a cash-out refinance is how you receive the funds. With a cash-out refinance, you receive a lump sum. But with a HELOC, you have access to these funds through a revolving line of credit. You only pay interest if you withdraw funds, and you're free to use either all of the funds or a portion across your draw period. This flexibility is better if:
If you're dissatisfied with your current home mortgage rate, a cash-out refinance is a way to address this situation. Since you're replacing your existing mortgage with a new one, you could get approved for new, lower interest rates. The 2021 market was very low for mortgage interest rates, and chances are you're eligible for a better rate than five, 10, or 20 years ago. You may also have a better credit score and a well-established employment history, all of which make you eligible for more favorable rates.
A HELOC, however, won't have any impact on your current mortgage interest rate.
Cash-out refinances require paying closing costs, and many lenders won't waive them. But a HELOC has a much more streamlined process and much lower closing costs. Many lenders may also waive or discount these costs for individuals with good credit.
We offer both cash-out refinances and HELOCs.
Want to learn more about HELOCs? Explore these resources for further reading:
*While the information provided is based on our understanding of current tax laws, and has been gathered from sources believed to be reliable, it cannot be guaranteed. Federal tax laws are complex and subject to change. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
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