Home Equity Loan vs. HELOC vs. Cash-Out Refinance: Which Is Better?

What Is a Home Equity Loan?

A home equity loan is a type of second mortgage that enables you to borrow against the value of your home, minus your remaining mortgage, by using your home as collateral. If you’re approved for a home equity loan, the lender will determine how much money you can borrow based on your home’s value and any debts against you. The bank will present that amount to you in a lump sum, which you must then repay at a fixed rate over a set number of years. If you default on your home equity loan, the lender reserves the right to take possession of your home.

Requirements to qualify for a home equity loan vary from lender to lender, but typically include the following:

• A credit score of 620 or higher
• More than 20% equity/a loan-to-value ratio (LTV) of 80% or below, as determined by an appraiser
• A low debt-to-income (DTI) ratio (ideally less than 43%, though some lenders may permit a higher DTI)
• Stable credit and bill repayment history
• Income and asset verification documentation

Home Equity Loan Pros & Cons

In order to fully understand whether taking out a home equity loan is the right decision for you, it’s important to get a complete picture of the associated advantages and disadvantages. When it comes to this option, pros include:

• Fixed interest rates over the life of the loan, which makes it easier to budget for monthly payments.
• Relatively low borrowing costs and interest rates when compared to unsecured loan types.
• The ability to use the cash however you like, meaning there are no restrictions on how you can spend the money you borrow.
• Greater borrowing potential — if you have sufficient equity, it’s easier to qualify for a larger sum of money with a home equity loan than other similar mortgage types.
• If you use the money you borrow for home improvements, your interest payments may be tax deductible.

Conversely, these are the cons to consider:

• Home equity loans use your home as collateral, which means if you fail to make payments on your loan, you could lose your home to foreclosure.
• As a form of second mortgage, you’ll still be responsible for making your original mortgage payments in addition to what you owe on your home equity loan.
• While fixed rates make your monthly payment predictable, other options (such as a HELOC, which has a variable interest rate) could come with lower overall rates.
• You’ll be responsible for paying fees, which could include application fees, appraisal fees, underwriting fees, document preparation fees, closing costs and more.
• You need to have sufficient equity in your home — if your LTV is too high, then you most likely won’t qualify.

What Is a Home Equity Line of Credit?

Similarly to a home equity loan, a HELOC is a way to convert the equity you’ve built in your home into cash. With the exception of credit score (HELOCs typically require a score of at least 680), eligibility requirements are also comparable. The main difference between the two is that with a HELOC, that sum is made available as a line of credit, which is accessible during an initial draw period of five to 10 years. Until the draw period ends, you can use the available credit much like a credit card and only repay the amount you use. During this draw period the monthly payment is usually interest-only, which allows for a more affordable monthly payment.

However, once the draw period ends the loan enters into the repayment phase, which is when you’ll be expected to make both principal and interest payments on the amount you borrowed until the debt is repaid in full. This period generally lasts for about 20 years.

Home Equity Line of Credit Pros & Cons

Advantages of taking out a HELOC are generally similar to those of a home equity loan, and include:

• Better rates than unsecured loan options, which is especially advantageous if you’re planning on using the money to pay off credit card or other types of personal debt
• Increased borrowing power if you’ve built enough equity in your home
• Potential for tax-deductible interest payments
• Variable interest means that you could pay less in interest over the life of the loan if rates decrease

Potential drawbacks include:

• Uses your home as collateral, meaning you’ll risk losing it if you can’t make payments
• Loss of equity, as a HELOC effectively sells off the share you’ve built over time
• Risk of amortization if the value of your home decreases
• A HELOC is a second mortgage, so you’ll be responsible for two monthly payments once you enter the repayment phase
• May not be an option if you don’t have enough equity in your home

What Is Cash-out refinancing?

Cash-out refinancing is when you leverage your home’s equity to borrow more money than is owed on your existing mortgage and receive the difference in cash. You can then use the cash to secure funding for major expenses, such as home improvement projects, medical bills, college tuition or high-interest debt, to name a few. There are three main cash-out refinancing loan programs:

• Conventional cash-out — available to homeowners with more than 20% equity
• VA cash-out — available for U.S. veterans and active service members, VA cash-out refinancing typically enables the borrower to access a larger amount of equity from their loan
• FHA cash-out — available to homeowners with more than 15% equity

Since a cash-out refinance is a new mortgage, all the standard application requirements apply. To qualify, homeowners should have:

• Owned the home for at least six months to one year (depending on the loan program).
• A credit score of 620 or higher (though the exact minimum varies from lender to lender).
• More than 20% equity/an LTV of 80% or below, as determined by an appraiser.
• A low DTI (again, ideally less than 43%, though some lenders may permit a higher DTI).
• Stable credit and bill repayment history.
• Income and asset verification documentation.

Cash-out Refinance Pros & Cons

If you’re considering applying for a cash-out refinance, it’s crucial to weigh the following pros and cons as you make your decision.

Benefits of a cash-out refinance include:

• If you purchased your home when mortgage rates were high, a cash-out refinance could give you a lower interest rate.
• If you use cash-out refinancing to pay off major expenses, such as high-interest debt, you could save thousands of dollars in interest and improve your credit score.
• Like home equity loans and HELOCs, the interest you pay on a cash-out refinance mortgage may be tax-deductible if you’re using the funds for home improvement projects.

These are the drawbacks to keep in mind:

• Securing a cash-out refinance will likely change the terms of your mortgage, either by increasing the amount you owe or possibly extending your repayment period.
• If you owe more on your loan than the value of your home, you could find yourself in a difficult financial position if property values fall.
• Like a home equity loan, there are fees associated with cash-out refinancing, specifically closing costs.

It’s also important to note that if you intend to use your cash-out refinance to consolidate debt, take care to develop a sustainable spending plan prior to making any payments. Many borrowers fall into a pattern of reloading — that is, taking out a loan to pay off existing debt and “reloading” their credit cards, only to rack up new debts — which, if they aren’t careful, could result in bankruptcy.

Differences Between a Cash-out Refinance and a Home Equity Loan

The most significant difference between a cash-out refinance and a home equity loan is that cash-out refinancing replaces your existing mortgage, whereas a home equity loan is additional to your existing mortgage. This is an incredibly important distinction because it means you only have to manage one loan payment instead of two, which is typically easier to keep track of and budget for.

Another key difference is that cash-out refinancing typically offers lower interest rates than a home equity loan. Although the up-front cost of a cash-out refinance is higher than the additional monthly expense of a home equity loan in the short-term, cash-out refinancing is less expensive in the long-term.

Which to Choose: Home Equity Loan vs. Cash-out Refinance

There’s a relatively easy way to determine whether a home equity loan or a cash-out refinance is the better option for your situation. Ask yourself these questions:

1. How do I intend to use the money?

Cash-out refinancing is better suited for planned expenses, such as home renovations or paying for college tuition. If you want to create a safety net for unexpected financial burdens (say, for example, your roof springs a leak and you determine it’s in need of replacement), a home equity loan is your best option.

2. Will I be able to pay off the loan over the next six months?

Although a cash-out refinance has a higher upfront cost than a home equity mortgage, cash-out refinancing comes with lower out-of-pocket monthly payment expenses, making it the more affordable option for long-term repayment plans. If you believe that you’ll realistically be able to pay off your loan in the span of six months, consider a home equity loan to save on upfront costs.

Differences Between a HELOC and a Cash-out Refinance

Cash-out refinances differ from HELOCs in many of the same ways that they do from home equity loans. HELOCs are also second mortgages, so they come with the same double monthly payment (in addition to the original mortgage) structure as home equity loans. This means that if you prefer to only keep track of one payment each month, getting a cash-out refinance could be the way to go.

If extra fees are a deciding factor for you, it’s important to know that while cash-out refinancing comes with closing costs, HELOCs typically do not. Other noteworthy differences include minimum credit score requirements (we recommend at least 680 for a HELOC and 620 for a cash-out refinance) and the way in which cash can be accessed — with refinancing, you’ll be given a lump sum while a HELOC allows for as-needed withdrawals.

Which to Choose: HELOC vs. Cash-out Refinance

If you aren’t sure which type of loan is best for you, ask yourself the following questions:

1. How’s my credit?

When it comes to choosing between a HELOC and a cash-out refinance, it’s possible that your credit score could be the deciding factor. If your score is below 680, chances are you won’t qualify for a HELOC, making a cash-out refinance the more viable option.

2. What terms am I most comfortable with?

Since a cash-out refinance replaces your current mortgage, you’ll need to accept an entirely new set of terms when you sign the agreement. That’s why it’s crucial to be sure that aspects such as the length of the loan and interest rates are favorable before making it official. On the other hand, a HELOC comes with its own set of terms, meaning that what you agree to will have no impact on your current mortgage.

All three of these loans have unique characteristics that will appeal to different groups of borrowers. If you aren’t sure which one you fit into, here are a few ways to help you decide:

When a Home Equity Loan Makes Sense

A home equity loan may be for you if you:

• Have at least 20% equity in your home
• Have a credit score above 620
• Want to create a safety net for unexpected financial burdens
• Can afford to take on a second monthly payment in addition to your current mortgage

When a Cash-out Refinance Makes Sense

You may want to consider cash-out refinancing if you:

• Would prefer not to take on a second mortgage
• Are looking for new terms for your home loan
• Will need more than six months to pay off the loan
• Have planned expenses, such as a home renovation project or significant personal debt

When a HELOC Makes Sense

Finally, a home equity line of credit could be the right solution if you:

• Have outstanding credit, typically a score of more than 680
• Have enough equity in your home — at least 20%
• Don’t need access to a lump sum of cash
• Would prefer a loan with a variable rate
• Can manage a new monthly payment in addition to your original mortgage

What is a home equity loan?

A home equity loan is a type of second mortgage that enables you to convert the equity you’ve built in your home to cash. Once approved, a lender will present the amount you qualify for as a lump sum, which you will then repay (with interest) over an agreed upon number of years. If for whatever reason you can not make the monthly payments, your lender reserves the right to take possession of your home.

What is a home equity line of credit (HELOC)?

A HELOC is similar to a home equity loan in the sense that it enables you to tap into the equity you have in your home. However, instead of being given a lump sum of cash, you’ll have access via a line of credit that you can draw from for a period of five to 10 years. Once this “draw period” ends, the loan enters repayment, during which time (usually 20 years) you’ll be expected to pay back what you borrowed plus interest.

What is a cash-out refinance?

Cash-out refinancing involves leveraging your home’s equity to borrow more money than is owed on your existing mortgage, receiving the difference in cash. You can then use the money to secure funding for major expenses, such as home improvement projects, medical bills, college tuition or high-interest debt, to name a few. This option will replace your original mortgage with a new loan that has its own terms and rates.

How can I tell which one is right for me?

Cash-out refinance vs. home equity loan, HELOC vs. cash-out refinance, HELOC vs. home equity loan — there’s a lot to consider when choosing between these options. Which one is right for you will depend on your circumstances and needs. As you make your decision, it’s important to ask yourself questions like “How do I intend to use the money?”, “Will I be able to pay off the loan within six months?”, “How’s my credit?” and “What terms am I most comfortable with?”.