If you’ve made regular mortgage payments for a while, you may have enough home equity to tap into and get cash to pay for anything you consider worthwhile.
As a homeowner with available equity in your home, you might consider a cash-out refinance or a home equity line of credit (HELOC).
But what’s the difference between a cash-out refinance and a HELOC? And which one should you use?
What is a cash-out refinance?
When you get a cash-out refinance mortgage, you get a new home loan for more money than you owe on your mortgage. You repay your old mortgage with the new home loan and keep the difference.
With a cash-out refinance, you get a single lump-sum cash payment that you can use for anything you consider important, whether that’s debt consolidation or home improvements.
What is a home equity line of credit
When you get a HELOC, you get access to a revolving line of credit that uses your home equity as collateral. You can use the credit in your HELOC as you would a credit card or other credit, up to a preset limit. When you pay off the balance, the credit replenishes, and you once again have access to the full credit amount.
What are the pros and cons of cash out refinance?
Before choosing to use your home equity for cash-out refinance, it’s important to understand the advantages and disadvantages.
Your home equity can equal thousands—or hundreds of thousands—of dollars that you can access at an interest rate typically lower than other options such as a personal loan or credit card interest rates.
You get a one-time lump sum payment in cash that you can use for any purpose that you deem appropriate.
If you use the funds from your cash-out refinance to “substantially improve” your home, the IRS allows you to claim a deduction* when you file your income tax.
If you opt for a lengthier mortgage term, you can extend the time you have to repay the new loan, which often translates into smaller monthly payment amounts.
Though this could be considered a con to some, cash out refinancing comes with a three-day cancellation rule. Lenders must give you three days after closing on the refinance to back out for any reason.
If you decide to repay your first mortgage and get a new one for more money, you’ll have a new mortgage term. Depending on your new home loan, that term could mean you’ll be making payments for a longer period than if you stayed with your original mortgage.
Just like with your original home loan, if you cannot repay your mortgage or miss multiple payments, your lender can take steps toward foreclosure.
Refinance loans are mortgages, and mortgage loans have closing costs. You may be able to roll any cash-out refinance costs into your loan balance, eliminating the need to make a cash payment at closing.
You’ll have to begin repaying the entire loan balance and principal right away.
What are the pros and cons of home equity line of credit?
We’ve mentioned that HELOCs and home equity loans are similar. Let’s look at the pros and cons of a HELOC to help you decide between the two.
Home equity line of credit—pros
HELOCs usually have lower interest rates compared to other personal loans and credit cards because they are secured against your home’s assessed value.
The lower interest rate can make a HELOC significantly more affordable than other borrowing options.
HELOCs allow borrowers to use as much money as they want—up to the preset credit limit—when they want for the draw period of the line of credit. (The draw period is when borrowers can withdraw funds.)
Unlike cash-out refinance, borrowers only have to pay interest on the funds they actually spend. In addition, with a HELOC, borrowers don’t have to repay the principal until the repayment period begins.
Home equity line of credit—cons
HELOCs can have an adjustable interest rate which can result in fluctuating monthly payments.
Additionally, if interest rates go up, you could see your monthly payments increase.
HELOCs can have ongoing fees to keep the line of credit active and in good standing. Your lender will advise you of any fees before you apply for a home equity line of credit.
Like a cash-out refinance, a HELOC uses your home as collateral. Failure to repay the loan, your lender might have to foreclose on the loan to recoup losses.
Because HELOCs are linked to your home equity, borrowers need to have enough equity in their home to offset the loan. Most lenders allow using up to 80% of your home equity for a line of credit.
Cash-out refinance or home equity line of credit—how do I know which is best for me?
Making sound financial decisions depend on carefully considering your current financial situation and what you hope to achieve with either a cash-out home equity line of credit or cash-out refinance.
It’s also a good idea to consider the other aspects of your life and lifestyle. Ask yourself questions such as these:
- Is my employment income secure?
- Can I comfortably afford the new monthly payment amount?
A cash-out refinance calculator can help you understand how much you could qualify for and what your projected monthly payment might be. This is valuable information when looking into financing options.
HELOCs can be good for borrowers who may not need a lump sum of money but rather need ongoing access to funds.
This can be useful for planned expenses like post-secondary education, home repairs, or renovations.
In addition, because HELOCs offer interest-only payments on the actual credit used during the draw period, borrowers don’t have the added burden of paying for something they haven’t used yet.
Alternately, a cash-out refinance can be good for borrowers who would prefer a single lump sum payment for a one-time expense, like a wedding or sudden, unplanned medical costs.
Get the information you need with AAA Banking
If you’re exploring financing options and are thinking about using your home equity, a cash-out refinance, or home equity line of credit are just two options available.
At AAA Banking, our trusted loan officers are available to answer your questions.
There’s never any fee to answer your questions, and getting the right information to make a smart financial decision is priceless. Reach out to a licensed loan officer at AAA Banking today.
*Consult your tax advisor for further information regarding the deductibility of interest and charges
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