HELOC vs Cash-Out Refinance: Which Is Best For You?

Even if your home isn’t fully paid off, it’s still possible to use it to access money quickly when you need it. If you’re trying to convert the equity you have in your property, there are several options available to you. 

Two of the most popular choices are Home Equity Lines of Credit (HELOCs) and cash-out refinancing. Both allow you to use your home as a tool to achieve financial flexibility, but they have different terms and conditions. 

To help you decide which is right for your situation, we’re breaking down HELOC vs cash out refinance. Read on to get a better sense of how they function, their key similarities and differences, and how to decide if either is right for you.

What is a HELOC?

HELOCs, like other lines of credit, are open-ended loans that allow borrowers to withdraw a certain amount of money over a given period. They’re secured using the borrower’s home equity as collateral and are generally lent to applicants in solid financial standing.

How Does a HELOC Work?

So how does a HELOC work? When an applicant applies for a HELOC loan, the institution they go to will want to ensure their ability to repay. Thus, the bank, credit union, or private lender will review their financial situation, typically looking for:

• Over 15% equity in their home
• A credit score above 600
• A debt-to-income ratio of 40% or less
• A strong income history stretching back at least two years

If an applicant fulfills these requirements, they’ll likely be approved. Lines of credit such as HELOCs function differently from conventional loans, and are generally broken down into two terms:

• The draw period
• The repayment period

During the draw period, the lender can take out funds as needed up to a previously agreed-upon amount (generally, around 85% of their equity). They’ll have to pay interest on any withdrawn funds during this time, but won’t yet be responsible for the principal sum.

After the draw period expires, the repayment period begins. The borrower then must begin making payments on the balance, pursuant to the terms of the agreement.

Pros and Cons of a HELOC

A HELOC is a swift way to convert your home’s equity, but it’s only one of several ways to do so. To get a better understanding of a HELOC’s finer points and how to decide if they’re the right type of loan for you, consider these pros and cons.

Advantages of a HELOC

Whether or not a HELOC loan is an advantageous financial tool depends on the borrower’s situation. In general, HELOCs tend to have some key benefits versus other loan types, including:

• Lower interest than other forms of personal lending, such as credit cards and personal loans
• Variable rates, meaning borrowers can withdraw strategically to create a lower interest rate 
• The ability to withdraw more money as needed (up to a pre-approved limit)
• Tax deductibility—if they’re used to buy, build, or significantly improve your property

Drawbacks of a HELOC

Despite these highlights, there are some notable downsides to taking out a Home Equity Line of Credit. Some potential drawbacks to think about before applying for one include:

• The potential for a higher interest rate if variable rates don’t fluctuate in your favor
• The prerequisites, which can be higher than other financial tools such as credit cards and personal loans
• Hidden closing costs on a HELOC agreement, such as appraisal fees for the property used as collateral
• The potential to lose your home if you’re unable to meet each monthly payment and the lender decides to foreclose

When is a HELOC a Good Idea?

So is HELOC a good idea and should you consider one? HELOCs are beneficial for borrowers who need a flexible agreement that allows them to withdraw money at will. If you’re funding a successful business or profitable investment property, then a HELOC might be the right choice. Borrowers should be cautious and only apply if they’re financially sound—as failure to meet debt obligations could result in property seizure.

What is Cash-Out Refinancing?

If you’re currently paying an existing mortgage on your home, learning how to do a cash-out refinance is another quick way to access a lump sum of money using your equity as collateral. During cash-out refinancing, borrowers increase the overall size of their mortgage in exchange for a cash payment.

How Does Cash-Out Refinancing Work?

When a borrower seeks cash-out refinancing, they’re looking for a lender to pay off their current mortgage, increase the loan amount, and provide the difference to them as a lump sum.

Homeowners will often work with the financial institution providing their current mortgage when pursuing a cash-out refinancing, although it’s not unheard of to seek out a new lender.

Pros and Cons of Cash-Out Refinancing

Cash-out refinancing can be an appealing borrowing option for homeowners with solid mortgage payment histories who are in need of quick cash. To determine if it’s the right loan structure for your situation, think about these unique upsides and downsides.

Advantages of Cash-Out Refinancing

Cash-out refinancing allows homeowners to tap into their equity in much the same way HELOCs do. It does offer some specific benefits, however, such as:

• A large, one-time lump sum that won’t tempt you to borrow further in the way a less restricted HELOC can
• A fixed interest rate that, when locked in at a low rate, can save borrowers significantly come repayment time
• The ability to collect the difference between your existing mortgage and subsequent loan tax-free

Drawbacks of Cash-Out Refinancing

Like all loan options, there are inherent risks that come along with cash-out refinancing. Some of the biggest drawbacks to this method of borrowing include:

• Extending the terms of your mortgage and size of payments as your overall balance increases 
• Being subject to extra costs if your credit score is below a certain threshold—such as those added from basis points and elevated interest rates
• Like HELOCs, potentially having to forfeit your property if you can’t adjust to the new loan term

When is Cash-Out Refinancing a Good Idea?

Cash-out refinancing can be a solid financial move if interest rates are trending lower than your current mortgage. By securing a loan at a lower interest rate, you may be able to save money in the long run—even if the repayment terms of your loan increase. Just be wary of the consequences of receiving a lump sum through cash-out refinancing without being able to repay it (i.e. property forfeiture).

Similarities Between HELOC and Cash-Out Refinance

Both HELOCs and cash-out refinancing are viable options for homeowners seeking to borrow large sums of cash. Furthermore, when breaking down the two, it’s plain to see that these lending methods have some striking similarities. 

Tapping into Home Equity

Both HELOCs and cash-out refinancing allow you to borrow using the equity in your home as collateral. In doing so, you’re effectively using your ownership stake in your property as a bargaining tool to negotiate a loan. While this can mean approval for large sums of cash, it also puts the ownership of your home at risk if you default on your loans. 

Interest Rates and Payment Structures

While interest rates are ever-changing and can be variable for certain types of loans, they’re often in the same ballpark for both HELOCs and cash-out refinancing. Both are also repaid in increments over a long period of time—generally, a decade or longer.

Differences Between HELOC and Cash-Out Refinance

Despite these similarities, there are some key distinctions between HELOCs and cash-out refinancing as well. To better understand the unique qualities of each, consider how these key aspects of the two differ.

Flexibility and Repayment Terms

HELOCs allow borrowers to withdraw money as they need it over an extended term known as the draw period. Then, they require borrowers to pay back whatever they’ve taken out during the subsequent repayment period.

Cash-out refinancing, on the other hand, delivers a single lump sum to borrowers. Whether they use it all or not, they’ll be responsible for paying back every cent through monthly payment installments which, unlike HELOCs, generally start relatively quickly upon taking out the loan.

Effect on Mortgage Structure

While a HELOC will generally have no effect on a homeowner’s mortgage, cash-out refinancing will often increase the installment sizes and extend their repayment terms.

Impact on Credit Score

Generally, assuming increased debt through cash-out refinancing has a negative impact on borrowers’ credit scores.

On the other hand, controlled investment using a HELOC could actually increase your credit score as it proves to financial institutions you’re a fiscally responsible individual.

Consider a Residential Sale-Leaseback Instead

A residential sale-leaseback agreement is a different method of converting your home’s trapped equity while still remaining in it as a renter. They don’t involve credit checks, lofty loans, or rigorous repayment plans.

They can allow homeowners to access even larger sums of cash and present several benefits over property-secured loans, including:

• Not locking you into a specific location or loan repayment terms
• Freeing homeowners from the burdens of property tax and home maintenance
• Not dragging down your credit score or forcing you to live with the constant worry of foreclosure

Key Takeaways

While HELOCs and cash-out refinancing allow you to use your home’s equity as a bargaining chip to secure large cash loans, they place your ownership at risk. If you miss payments on either, the lender could foreclose on your property—leaving you with no home and only debt to show for it. 

If you have a denied HELOC or refinance application, consider residential sale-leaseback agreements as an alternative to HELOCs and cash-out refinancing. They allow you to convert your home’s equity and remain in it afterward, if you choose. Most importantly, they don’t cause you to incur debt that can risk your property with nothing in return. 

Sources: 

1. Beck, Rae Hartley. “Home Equity Line of Credit (HELOC).” Investopedia. May 8, 2023.
2. Hayes, Adam. “Line of Credit (LOC) Definition, Types, and Examples.” Investopedia. January 19, 2022. 
3. Chen, James. “Cash-Out Refinancing Explained: How It Works and When to Do It.” Investopedia. May 26, 2022.
4. Parker, Tim. “Cash-Out Refinance vs. Home Equity Loan: What’s the Difference?” Investopedia. May 16, 2023.
5. The Investopedia Team. “Does Mortgage Refinancing Affect Your FICO Score?” Investopedia. June 11, 2022.
6. Langone, Alex and Watt, Katherine. “How Does a HELOC Affect Your Credit Score?” Computer Network. March 29, 2023.