Hello World! Welcome Friends! A cash-out refinance and home equity line of credit are ways to turn your home’s equity into funds for your other goals. They are often mentioned in the same context. Although both options allow you to tap into your property’s value (the part of your home you own), these two financing options aren’t the same and have different benefits and drawbacks.
If you’re looking to leverage your home equity, learn how these two financing options work and make an informed decision.
What Is a Cash-Out Refinance?
A cash-out refinance allows you to undertake a larger mortgage in exchange for accessing the equity in your home. It doesn’t add to your monthly payment, but the length of the loan. Once you pay off your old mortgage, you start paying off the new one. Some states may differ regarding cash-out refinance, such as California. Learn more about the cash-out refinance in California.
The process of cash-out refinancing is similar to the process you went through for your old mortgage. You choose your lender, apply, and provide documentation. And if you get approved, you get the loan. That said, here are the requirements for approval:
- You need equity in your home to capitalize on cash-out refinance. For that reason, you should look at your home’s equity beforehand to make sure you can cash out enough to reach your goals.
- You’ll need a debt-to-income (DTI) ratio of less than 50%.
- You typically need a credit score of at least 620.
What Is a Home Equity Line Of Credit?
A home equity line of credit (HELOC) is a type of second mortgage that lets homeowners borrow money against the equity they have in their homes. You can access and use the funds as you please – within a certain timeframe and up to a certain limit.
Unlike home equity loans which come as a one-time, lump sum of cash, HELOCs offer flexibility. You can borrow against your credit line at any time. For that reason, HELOCs are popular as an emergency source of funds because there are no interest charges for unused funds.
With HELOC, you’re adding another loan to your property, meaning an additional monthly mortgage payment to think about. There are separate periods for borrowing and repayment. However, you’ll make payments on the loan through both periods.
The first period is known as the draw period. In this period, your line of credit is available for use. You can borrow as needed while making interest-only or minimum payments on what you owe.
When your draw period ends, you can’t access HELOC funds and will have to start making monthly payments that cover the principal balance and interest. That is known as the repayment period. The length of the repayment period depends on the type of the loan. However, you may be able to prolong your draw period by refinancing your HELOC.
Below are the requirements for approval for HELOC:
- You need equity in your home for a HELOC to be worthwhile.
- You’ll need a lower DTI ratio. Most HELOC lenders are looking for 43% or lower.
- HELOCs tend to be more challenging to get than a first mortgage. The interest rates can get hefty if you’re not careful. That’s why you shouldn’t consider HELOC unless you have a credit score of 700 or higher.
The Benefits of Cash-Out Refinance vs. Home Equity Line of Credit
With cash-out refinance, the borrower can realize some of their home value in cash. With a standard refinance, the borrower would only see a decrease in their monthly payments rather than cash in hand.
This type of refinancing can go as high as a 125% loan-to-value ratio, meaning the refinance pays off what they owe, and then the borrower may be eligible for up to 125% of their property’s value.
Moreover, repaying a cash-out loan requires a single monthly payment. That could be easier to budget than having two monthly payments.
With HELOC, you access the funds only when you need them, and untapped funds won’t incur interest as you pay only for what you use. If you don’t use funds, you may not have to make payments. However, there may be a small monthly maintenance fee to keep it open.
Moreover, HELOCs typically have lower closing costs than other home equity loans. In addition, they can be a good source of emergency funds.
The Drawbacks of Cash-Out Refinance vs. Home Equity Line of Credit
With cash-out refinance, you’ll likely have to pay more in closing costs than if you use a home equity loan or HELOC. Moreover, if mortgage rates have increased since you obtained your initial mortgage, you could pay more interest over the life of the loan.
Also, if the equity in your property falls below 20% after doing a cash-out refinance, your lender could charge you private mortgage insurance.
It can be easy to complicate your financial situation with HELOC, using more money than you need or can payback. The varying payments can also be challenging.
The principal and interest payment in the repayment period often increases over the interest-only payment amount during the draw period. That can cause payment shock for some borrowers and even cause financial difficulties.
Should You Get a Cash-Out Refinance or HELOC?
When choosing between a cash-out refinance and HELOC, consider the following factors.
Think About Payment Options
If you need a one-time, lump sum of money, a cash-out refinance may be a better choice. However, if you want to have access to your funds over some time, HELOC may be more suitable because the draw period typically lasts around ten years. And during that time, you can use your money as needed.
Consider Loan Terms
A cash-out refinance extends the length of your current mortgage loan, and HELOC adds a second loan to your existing time frame and added monthly payment. Therefore, if you can’t commit to the additional monthly expense, the cash-out refinance is likely a better option.
Compare Rates
If you prefer fixed rates, go for a cash-out refinance. Their payments won’t change over time. However, if you don’t mind an adjustable rate, HELOC may give you access to more equity overall.
Calculate Closing Costs
HELOC may be a better option if you want to pay less upfront because refinancing incurs closing costs, while HELOCs typically don’t.
Also, consider your private mortgage insurance (PMI) when estimating closing costs as it applies to refinancing. PMI protects your lender if you stop paying out your loan. For that reason, your lender will likely require you to pay PMI if you make a down payment of less than 20% on your home.
In some cases, using HELOC can help you bypass paying for PMI altogether.
Remember Taxes
There are also tax implications of cash-out refinancing vs. taking out HELOC.
The internal revenue service (IRS) views refinance as debt restructuring, meaning the deductions and credits you can claim are considerably smaller than when you got your first mortgage. Since cash-out refinances are considered loans, you won’t need to include the cash from your refinance as income when filing the taxes.
With both HELOC and cash-out refinance, your cash will be tax-deductible if used for capital home improvements, like renovations and remodels.
Choose What Suits You
After reading this article, you likely have an idea of which financing suits your situation. Both cash-out refinance and HELOC can benefit you if you obtain a favorable interest rate on your new loan and use the money responsibly.
Before making your choice, think about how much money you need and how you will use it. Also, consider fees, interest rates, taxes, and monthly payments as you weigh your options.
Click the links below for any posts you have missed:
Six Secrets to Make Your Home Look Spectacular
How to Prevent Water Damage In Your Home
How to Pressure Wash Siding and Gutters
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