That home equity you’ve accrued can be a powerful asset that comes in handy when you need extra cash. Fortunately, you can tap into it in multiple ways, including a cash-out refinance or a home equity line of credit (HELOC). Each option has its pros and cons.
Read on to learn more about a cash-out refinance vs. HELOC, how each works, the credit score and debt-to-income ratio you’ll need, the interest rate, monthly payments, and closing costs you can expect, when and how you’ll access the funds, and more.
Key Takeaways
- A cash-out refinance loan lets you take out a new mortgage that exceeds the amount you currently owe, giving you the extra funds as cash.
- A home equity line of credit (HELOC) is a flexible credit line that lets you borrow against your home’s equity up to a certain limit, with the option to withdraw and repay funds as needed.
- Each option has different eligibility requirements, costs, and advantages and disadvantages that borrowers should consider carefully to make the right choice.
How Equity Works
Home equity is the difference between your home’s market value and the balance of your outstanding mortgage. It’s essentially the amount of your property’s worth that you own outright and could pocket today if you sold your home.
For example, if you own a $400,000 home but still owe $250,000 on your mortgage loan, your equity portion would be $150,000, meaning you’ve accrued about 38% equity in the property.
“Home equity is accrued in different ways. As you make your mortgage payments, a portion goes toward reducing the principal owed, thereby increasing your equity,” explains personal finance expert Adam Koprucki, founder of RealWorldInvestor.com. “Also, if your home’s value increases, your equity grows – even if you don’t pay down the mortgage. And renovations or improvements you make that boost your home’s value can further increase your equity.”
According to Tom Hutchens, president of Angel Oak Mortgage Solutions, there are plenty of good reasons for liquidating home equity.
“The most common uses for home equity include funding home improvement projects, consolidating debt, investing in a business, paying for major life expenses like a college education, or making another large purchase like a second home,” Hutchens says.
There are a few ways you can tap into your home equity: a home equity loan, a home equity line of credit (HELOC), or a cash-out mortgage refinance loan. The latter two are the most popular options among many homeowners.
» MORE: See today’s refinance rates
How They Work
A cash-out refi and HELOC each work differently but accomplish the same goal: to easily tap into your accumulated home equity and provide convenient access to funds that you can use for virtually any legal purpose. Let’s take a closer look at each option and their plusses and minuses.
How a cash-out refinance works
A cash-out refi is like getting a new mortgage but with a twist: You refinance and replace your existing mortgage loan for more than what you currently owe and take the difference out at closing as cash. You’ll use your home as collateral for the loan, which means you risk losing your property to foreclosure if you don’t repay your debt as agreed upon.
“It’s a good option if you’ve built up significant equity and need a large lump sum of money for something like a major renovation, debt consolidation, or big purchase,” notes Carl Holman communications and content for A&D Mortgage.
Good candidates for pursuing a cash-out refinance include homeowners who have accrued at least 20% equity; those who want to consolidate high-interest debt, finance home improvements, or cover large expenses; and borrowers who can secure a lower interest rate on the new mortgage compared to their current rate.
Credit Score Requirements
Your credit score is a three-digit number that indicates your creditworthiness. The higher your score, the more likely you will qualify for a cash-out refinance with better rates and terms.
For a cash-out refinance, aim to have a minimum credit score of 620, although a score of 700 or higher could secure better terms. Here’s a breakdown of the minimum credit score typically needed by loan type:
- Conventional cash-out refi: 620
- FHA cash-out refi: 600-620
- VA cash-out refi: 620
- USDA cash-out refi: 640
Debt-to-income ratio
Your debt-to-income (DTI) ratio measures your ability to manage debt, expressed as a percentage of your gross monthly income. Most lenders look at your back-end DTI ratio, which accounts for all debts.
For instance, with a $5,000 monthly income, if $1,200 goes to housing, and with $600 in other debts, the back-end DTI is 36%. Lenders use this ratio to determine how much additional debt a borrower can handle, with lower ratios often resulting in better loan terms.
“Many cash-out refinance lenders prefer a DTI ratio of 50% or lower,” says Hutchens.
Here’s the max DTI recommended based on loan type:
- Conventional cash-out refi: 36% to 43%
- FHA cash-out refi: Up to 50%
- VA cash-out refi: Up to and sometimes over 50%
- USDA cash-out refi: 41%
Loan-to-value ratio
In a cash-out refinance, your loan-to-value (LTV) ratio determines how much of your home’s appraised value you can borrow, typically up to 80%. For example, if your home is valued at $300,000 and you owe $150,000 on your mortgage, you could borrow up to $240,000, using the remaining amount as cash after paying off the existing mortgage.
Here are the maximum LTVs allowed for a cash-out refinance based on loan type:
- Conventional cash-out refi: Up to 80% of the home’s appraised value
- FHA cash-out refi: Up to 80% of the home’s appraised value
- VA cash-out refi: Up to 100% of the home’s appraised value
- USDA cash-out refi: Commonly up to 80% of the home’s appraised value
Interest rate and monthly payments
With a cash-out refinance loan, you can opt for either a fixed interest rate or an adjustable rate. Rates can vary widely from lender to lender and based on loan type; you could be charged a higher rate for a conventional versus an FHA, VA, or USDA loan, for instance.
At the time of this writing, the average fixed rate for a 30-year cash-out refinance conventional loan was 6.55%.
Let’s say you currently own a home worth $400,000 and have a remaining loan balance of $250,000. If you refinance to a new 30-year cash-out refi loan at a fixed rate of 6.55%, and take $50,000 out at closing, your new monthly principal and interest payments would be $1,906.
Closing Costs
Regardless of whether you opt for a USDA, or VA cash-out refinance loan, you will be charged closing costs. These typically equate to 2 to 5% of your total loan amount. Common closing costs include:
- Loan origination fee: generally ranges from 0.5% to 1% of the loan amount.
- Title search and title insurance: usually costs between $500 and $1,000
- Appraisal fee: typically between $300 and $600
- Escrow fees: often ranging from $200 to $500, depending on location
- Credit report fee: usually $30 to $50
- Recording fees: generally between $50 and $150.
You could also be charged additional fees depending on the loan type, including:
- FHA cash-out refi: Upfront mortgage insurance premium (UFMIP) of 1.75% of your loan amount
- USDA cash-out refi: Guarantee fee of 1% of the loan amount
- VA cash-out refi: Funding fee of 1.4% to 3.6% of the loan amount, depending on your service status and whether it’s a first or subsequent use of VA benefits.
How you access your money
With a cash-out refinance loan, you receive your tapped equity right away in a lump sum.
“After closing, the cash-out portion is typically disbursed via wire transfer or check and can usually be accessed immediately,” explains Koprucki.
Note that it can take three to five days after the closing to receive your funds.
How a HELOC Works
A HELOC, on the other hand, works more like a credit card than a loan. It’s a revolving line of credit secured by the home equity you have in your home.
“With a HELOC, you can borrow as needed at a time of your choosing, up to a pre-approved limit, during what’s called a ‘draw period’–which is typically the first 3 to 10 years. During the draw period, you make interest-only payments on whatever you borrow,” continues Hutchens. “Then, when the draw period ends, the repayment period begins, often lasting 10 to 20 years. During the repayment period, you can no longer borrow funds and must repay both the principal and interest, resulting in typically higher monthly payments.”
Worthy prospects for a HELOC include homeowners who desire flexible, ongoing access to funds for goals like home improvements, education, or emergency expenses, as well as those who prefer a line of credit they can draw from as needed rather than a lump sum.
Credit Score Requirements
As with a cash-out refi, you’ll need to have a minimum credit score to qualify for a HELOC.
“Lenders usually want to see a credit score of at least between 620 and 700, with better terms offered to those with higher scores,” Holman says.
Debt-to-income ratio
You’ll also have to demonstrate a preferred DTI ratio to be eligible for a HELOC. The experts say many lenders allow a max DTI of 43%, although some go up to 50%.
Loan-to-value ratio
LTV ratio is important when it comes to getting a HELOC.
“Most lenders want you to keep your LTV at 85% or lower, meaning you should have at least 15% equity built up in your home,” adds Holman.
Keep in mind that some lenders require an LTV of no more than 80%, however.
Interest rate and monthly payments
HELOCs typically have variable interest rates, which currently might range between 7% to 10%, per Holman.
The interest rate on your HELOC adjusts periodically as detailed in your HELOC agreement. Typical adjustment periods are monthly, quarterly, or annually.
Case in point: If your HELOC has a quarterly adjustment, the rate will be recalculated every three months based on the current index value.
Closing Costs
Just like a cash-out refi, you’ll pay closing costs for HELOC, which may average 2% to 5% of your credit line/borrowed amount. But some lenders charge minimal to no closing costs, so it pays to shop around.
How you access your money
Again, your funds can only be accessed during the HELOC’s draw period. To do so, you can use online transfers, checks, or a credit card provided by the lender.
What’s the best option for you?
Should you go with a HELOC vs. refinance? What’s the ideal choice for you? The answer will depend on many factors.
“For smaller or temporary needs, a HELOC is often best,” advises Lauryn Grayes, founder of Wealth Gems Financial Solutions. “For bigger needs at a good rate, a cash-out refinance loan can save you more money in the long term. But be careful to only tap your equity judiciously, as it reduces ownership stake and is risky if home values fall.
Consider your needs, timeline, credit rating, and amount of home equity accrued to choose the right option.”
Hutchens agrees.
“A cash-out refi may be best for those looking to lower their mortgage interest rate while also accessing a large lump sum. It’s ideal when you have a good interest rate on your new mortgage and need funds for a specific, large expense,” he says. “A HELOC, meanwhile, is best for homeowners who need flexible access to funds over time – like ongoing home renovations. It’s also beneficial if you don’t want to change your lower existing mortgage rate or reset your term, which can add extra years to your mortgage repayment schedule.”
Let’s assume you need $50,000 upfront for a home renovation. In this case, “a cash-out refinance might be the way to go,” suggests Holman. “But if you are planning multiple smaller improvement projects over time, a HELOC could make more sense.”
If you are seeking to consolidate debt, on the other hand, a cash-out refi is likely the better choice.
“Imagine you have $50,000 in high-interest debt. If you refinance at a fixed 6.5% rate, you could pay off that debt and save a lot of money on interest,” Koprucki says.
To help you make a more informed choice and avoid borrower regret, consult with a trusted financial advisor and/or experienced lending professional who can help you weigh the pros and cons based on your particular financial situation and objectives.
“Don’t forget to consider alternative funding sources too, including a home equity loan, personal loan, or credit card,” adds Holman.