If you’re trying to secure a large sum of money using your home as collateral, you have several borrowing options to choose from. Three popular choices are cash out refinancing, home equity loans, and Home Equity Lines of Credit (HELOCs).
While all three can help homeowners convert the equity in their homes, they all come with their own unique conditions. So, what are the differences between a cash out refinance vs home equity loan, a cash out refinance vs a HELOC, and a HELOC vs a home equity loan?
Serious sums of money are on the line when dealing with such loans, so it’s crucial to be well-informed before committing to any contracts. Read on to learn about their terms, weigh their pros and cons, and see if any of them are right for your situation.
What is a Cash Out Refinance?
A cash out refinance loan can be obtained for homes that already have an existing mortgage. Essentially, the homeowner agrees to “cash out” their current mortgage and replace it with another one of higher value.
The difference is then paid to them in full, and they begin making payments pursuant to the terms of their new home loan agreement. Since the original mortgage is paid off, any payments the homeowner was making on it come to a complete stop.
Pros and Cons of Cash Out Refinance
In specific situations, it can be beneficial for homeowners to apply for a cash out refinance loan. A couple of benefits of obtaining such loans include:
- Better terms – If the terms of your original mortgage are less than favorable, cash out refinancing can be an opportunity to rework your loan conditions. Additionally, if your circumstances have changed and you can afford higher monthly payments, a cash out refinance may be your opportunity to own your home outright quicker and with less interest.
- Adding a copayer to the agreement – If you’ve just gotten married or are using the equity in your home to fund a joint business venture, cash out refinancing can allow you to add a partner to the terms of your mortgage agreement.
Despite these upsides, cash out refinancing can carry some significant drawbacks. Some of the biggest downsides to obtaining these loans include:
- Increasing the length of your mortgage – Often, cash out refinancing lengthens, rather than shortens, the terms of a homeowner’s mortgage. An increase in loan size means more money to pay back, often leading to extra years added onto the finish line.
- Larger payments – It’s simple math: a bigger principal equates to larger monthly installments. As long as you have the means of meeting them, this isn’t an issue when it comes to a cash out refi. But, if you fall behind on your payments, problems could arise.
- The potential to lose your home – Like any property-secured loan, the lender can choose to foreclose on your home should you miss your payments. More stringent mortgage terms after cash out refinance loans can increase the likelihood of homeowners losing their properties.
What is a Home Equity Loan?
A home equity loan is, as it sounds, a lump-sum loan issued using the equity one has in their property as collateral. Generally, it’s granted based on the difference between the homeowner’s mortgage principal and the home’s current value.
As such, homeowners need to get an appraisal before any such loans are given out. The actual amount lenders will approve varies based on other existing debts and mortgage payment history, as well as current equity.
Pros and Cons of a Home Equity Loan
To better understand if this is the right option for you, let’s explore the pros and cons of home equity loans. Like cash out refinancing, home equity loans allow homeowners to convert money when they need it. They also present a few other advantages, including:
- Relatively low interest rate – While they’re usually higher than rates for initial mortgages, the interest rate on home equity loans is generally lower than other forms of unsecured debt, like credit cards.
- Being easy to obtain – Since home equity loans are secured (i.e. backed with a valuable asset as collateral) lenders are far more likely to hand them out than other forms of personal loans.
These upsides, however, carry with them very stark and unignorable negatives, some of which include:
- The potential to lock yourself into high payments – Home equity loans come with fixed interest terms. So, if rates drop during the course of your contract, you’ll still be paying the higher interest of a bygone era.
- The cost of appraisal – As mentioned, home equity loans require homeowners to get their property appraised—and generally, it’s at their own expense. Such services can be costly, especially when paying for them doesn’t guarantee approval for a loan.
- The propensity for debt reloading – Debt reloading is a vicious cycle where an individual can use new loans to pay off existing debts. Home equity loans can fuel this habit as they present an accessible option for homeowners who need quick cash.
- The possibility of losing your home – Like other secured loans, failing to meet the terms of a home equity loan can give lenders the right to claim your property in lieu of payment.
What is a HELOC?
A HELOC is, like a home equity loan, debt secured using your home’s equity. Instead of receiving a lump-sum loan, however, borrowers gain access to a line of credit that they can convert whenever they need money.
How does a HELOC work? Generally, HELOCs have a set term in which borrowers only have to pay the interest on any money they withdraw. Then, after this initial period is up, they’re responsible for paying back the interest and the principal on what they’ve borrowed.
Pros and Cons of a HELOC
If you’re considering this type of loan, you might be wondering, is HELOC a good idea? HELOCs, like other lines of credit, are considered flexible borrowing options. Some of the advantages of these types of loans include:
- The freedom to take what you need – Unlike lump-sum loans, HELOCs allow borrowers to take out money as they need it. So, even if your reason for borrowing costs more (or less) than you anticipated, you’ll still have whatever funds you need.
- Potential tax breaks – If you use the money from a HELOC to make significant improvements to your home, there’s a chance the interest will be tax deductible pursuant to the Tax Cuts and Jobs Act of 2017.
Despite their flexibility, HELOCs aren’t necessarily the optimal choice for every homeowner. Some of their key disadvantages include:
- Deceptively enticing terms – The freedom and flexibility of a HELOC can cause homeowners to thoughtlessly withdraw without checking their spending habits. Doing so can cause them to rack up a larger principal than intended and lead to higher totals than standard lump-sum loans.
- Undecided interest rates – A variable interest rate means borrowing can cost different amounts at different times. If rates go up during your loan term, you’ll be paying more than you would have on a fixed-term, lump-sum loan.
- The chance to lose your home – Like home equity loans and cash out refinancing, HELOCs are property-secured and at risk of being foreclosed on if you fall behind on payments.
Comparing Cash Out Refinance, Home Equity Loan, and HELOC
If you’re trying to secure a loan with your home as collateral, cash out refinancing, home equity loans, and HELOCs are all viable options to consider.
They’re all, in essence, different ways of either renewing or extending your current mortgage in return for the ability to borrow large amounts of money. While the terms and conditions of each vary, they all have one thing in common: failure to meet your payment obligations can lead to foreclosure on your home.
Sale-Leaseback: A Different Option
If you’re trying to convert your home’s equity, there’s a way you can do it without worrying about losing it to lenders through a cash out refi, home equity loan, or HELOC.
A residential sale-leaseback is a kind of real estate contract in which a homeowner sells their property and agrees to rent it back from the buyer afterward. Much like property-secured loans, they allow you to quickly convert your home’s equity.
Unlike these risky forms of debt, however, you’re not required to pay back the money you get from a residential sale-leaseback agreement. To that end, this option presents a savvy alternative for homeowners who want to use the money caught up in their equity but still want to remain in their homes. Explore the benefits of a sale-leaseback to make the decision that’s most tailored to your needs.
Which is Right for You?
Each type of loan is best suited to specific scenarios. Cash out refinancing, for instance, might be right for a couple combining households so that both parties can have a stake in their current property.
The flexibility of HELOCs, on the other hand, might be an ideal fit for funding a business venture when you don’t know exactly how much money you’ll need.
Assess your own circumstances, weigh the pros and cons of each type of real estate transaction, and decide if any is right for you. Just be sure that, whichever you choose, you’ll be able to meet the obligations of your new contract.
And, if you find that none of them are favorable for your situation, perhaps a residential sale-leaseback is the option you’ve been looking for.
While cash out refinancing, home equity loans, and HELOCs have varying terms and conditions, they all are secured using your property as collateral. They can give you quick access to large sums of cash, but they can also cause some homeowners to lose their properties should they fail to repay their loans.
If you’re looking to convert your home’s equity, consider a sale-leaseback agreement as an alternative to property-secured loans.
- Chen, James. “Cash-Out Refinancing Explained: How It Works and When to Do It.” Investopedia. May 26, 2022. https://www.investopedia.com/terms/c/cashout_refinance.asp
- Kagan, Julia. “How a Home Equity Loan Works, Rates, Requirements & Calculator.” Investopedia. February 13, 2023. https://www.investopedia.com/terms/h/homeequityloan.asp
- Zhang, Alice. “Reloading.” Investopedia. January 25, 2022. https://www.investopedia.com/terms/r/reloading.asp
- Kurt, Daniel. “HELOC (Home Equity Line of Credit) and Home Equity Loan: Comparing Your Options.” Investopedia. April 19, 2023. https://www.investopedia.com/mortgage/heloc/