HELOC or Cash-Out Financing: What's The Difference?
If you're like many Americans, your home makes up a large part of your net worth. Exactly how much net worth you have tied up in your home depends on your home's equity, which is the value of your home minus whatever you still owe on your mortgage. For example, if the market value of your home is $200,000, but you still owe $150,000 on your mortgage, then you have $50,000 of equity in your home.
You may want to tap into your home's equity for any number of reasons:
- Perhaps you want to renovate your home, hopefully increasing its value even more.
- You may want to pay for your child's education.
- Maybe you have aspirations to start a new business.
- Or perhaps it's time to take that dream vacation you've always wanted.
Tip: Before you tap into the equity you have in your home, consider how you'll use the funds, your current financial situation, and your future plans.
Problem is, it's tough to convert that equity into cash unless you sell your home.
Assuming you'd like to stay in your home, the two most common options for converting your home's equity into cash are cash-out refinancing1 or a home equity line of credit (HELOC).1 Let's examine these two very different options and explore which makes the most sense for you.
1. Cash-out refinancing
A cash-out refinance is a type of mortgage refinancing. Here's how it works: you apply for a new loan that's greater than the amount of your existing mortgage but less than the current value of your home. You then use the money from the new loan to repay your original mortgage — and pocket the rest of the cash to use as you please. Then, you continue making monthly mortgage payments until the loan is repaid in full.
With cash-out refinancing, you make monthly payments at a set interest rate until the amount you borrowed is repaid. While there are different loan terms you can choose from when you refinance, the most common are 15-year and 30-year loans.
2. Home equity line of credit (HELOC)
A HELOC, or home equity line of credit, is a line of credit that's based on the equity in your home, and a HELOC is separate from your mortgage. The equity in your home serves as collateral for this line of credit.
With a HELOC, you can borrow the amount you want whenever you want, provided that the line of credit is open and you have funds available. During the period of time you can borrow from your HELOC — known as the draw period — you must pay at least the interest on whatever your outstanding balance is. At the end of the draw period, you enter the repayment period, where you must repay any outstanding balance. A common term for a HELOC is 25 years, with the draw period lasting 10 to 15 years and the repayment period lasting another 10 years.
Which is right for you?
One size does not fit all when it comes to making the decision on cash-out refinancing or getting a HELOC. Since it all depends on your personal situation, here are some scenarios to help illustrate which approach might be a better fit:
- If mortgage rates are considerably lower today than they were when you got your mortgage, consider a cash-out refinance. This will help you access the cash you want while potentially saving you money on your mortgage in the long run.
- If you want a lot of flexibility, consider a HELOC. These work similarly to credit cards, in that it's a revolving line of credit and you only pay interest on what you borrow. You have the option to borrow a large sum, but if you borrow just a small amount, you'll pay interest only on what you used (not the full amount available).
- If you want a fixed interest rate with a set payment schedule, you'll likely want a cash-out refinance. HELOC interest rates are variable. If you refinance to a fixed-rate mortgage, you know exactly how much you'll owe each month.
- If you need access to your equity fast, a HELOC likely makes the most sense because the approval and origination process is much easier and faster. This is great for things like home renovations or improvements.
Keep in mind, cash-out refinancing and a HELOC are only two options for leveraging your home's equity. To help you decide what's best for you, talk to a trusted local banker or mortgage loan originator near you.
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