Home Equity Loan, HELOC, Cash-Out Refinance: How Do They Differ?

What Is a Home Equity Loan?

Home equity loans are a type of second mortgage that use the equity in your home as collateral. Lenders disburse the loan in one lump sum with a fixed interest rate and typically require you to repay it via monthly installments. Most lenders let you borrow up to 75% to 85% of your home's equity.

Pros and Cons of a Home Equity Loan

If you need cash and have sufficient equity built up in your home, a home equity loan can be a good option. However, there are drawbacks to consider.

Pros

• IRS tax break: You may be eligible for a tax break if you make substantial improvements to the home.
• Fixed interest rate: You will pay the same interest rate over the life of the loan, so your rate will stay the same even if interest rates are rising. (This could also be a con, for reasons explained below.)
• Fixed payments: Since you're repaying a lump sum with a fixed interest rate, your payments will remain the same.
• Low rates: Because you're reducing risk to the lender by using your home as collateral, you'll likely qualify for lower interest rates than on many other types of loans.

Cons

• Your home is the collateral: Missing payments or defaulting on your loan could cause you to lose your home.
• Closing costs: As with a standard first mortgage, you'll have to pay closing costs that can run from 2% to 5% of the loan amount.
• Two mortgages: A home equity loan will add another mortgage on top of your primary mortgage, increasing your overall debt and reducing your disposable income.
• Credit score requirements: Lenders usually require a good credit score and a low debt-to-income ratio (DTI) to offer a loan with the best rates. Plus, you must also maintain a loan-to-value (LTV) ratio of 85% or lower.
• Fixed interest rate: While a fixed interest rate can definitely benefit you in an environment where interest rates are rising, it also potentially means being stuck with a higher rate when rates are falling.

When to Choose a Home Equity Loan

There are very few limits on how you use your home equity loan. Depending on your budget, you can opt for a shorter term with higher monthly payments or a longer term with lower payments. Either way, you have access to your money right away to be used for home improvements, an emergency expense, college costs or a wedding, to name a few common uses.

And, as the interest rate can be less than on a personal loan, consolidating high-interest credit card debt with a home equity loan might make sense.

What Is a HELOC?

HELOCs let you tap into the equity in your home and use the cash as needed, much like a credit card. A HELOC is flexible and lets you borrow, as needed, up to a predetermined limit and repay the debt over time.

Lenders base your credit limit on your credit score and credit history as well as the appraised value of your home (minus the balance you owe on your existing mortgage). HELOCs usually have a fixed term and adjustable rates. Since you're not borrowing a lump sum with a HELOC, you only pay interest on the amount you actually borrow, not the total amount of your line of credit.

Pros and Cons of a HELOC

HELOCs offer some benefits, along with a few disadvantages.

Pros

• High borrowing limit: Generally, HELOCs let you borrow up to 85% of the equity in your home.
• Lower interest rates: Although similar to a credit card, many HELOCs offer lower interest rates and higher borrowing limits.
• Pay interest on what you spend: You only pay interest on the amount you borrow, not the total amount of your credit line.
• Many uses: You can typically use the money from the HELOC for almost anything you want.

Cons

• Variable interest rates: HELOCs usually come with variable interest rates. So, if interest rates rise, so will the interest you pay on the amount you borrow. You're at an advantage if interest rates fall, however, since the rate on your loan may also decline.
• Fees and other costs: Some lenders charge closing costs, appraisal and application fees that can add to the amount you have to pay back.
• Limited draw period: Most HELOCs only let you access your funds for a set period of time. After your draw period, you enter the repayment period and can't borrow more from your HELOC. During the repayment period, you'll pay back both the principal and interest balance on your HELOC.
• Reduces your equity: A HELOC can lower the equity built up in your home. In some cases, it can take you back to when you first bought your home.

When to Choose a HELOC

A HELOC might make sense when you want to borrow against the equity in your home to make renovations or improvements that will increase your home's value. It's also possible to use a HELOC to consolidate high-interest credit card debt, but it can be a risky move since a HELOC uses your home as collateral.

A HELOC offers the flexibility to borrow (and use) only what you need, make the repayments, and repeat. Some lenders may also let you convert a portion of your balance to a fixed rate, offering the option for consistent monthly payments. Plus, you can use the funds for almost anything.

What Is a Cash-Out Refinance?

Similar to a home equity loan and HELOC, a cash-out refinance lets you convert home equity into cash. It works by replacing your existing mortgage with a new, larger loan and issuing the difference to you in cash. The new loan may offer better terms, a lower interest rate and lower monthly payments. However, if you opt for a longer term, you will pay more interest over time.

Your credit score and loan-to-value (LTV) ratio will likely determine how much cash you can receive with your cash-out refinance. Many lenders also charge closing costs in the range of 2% to 6%. On the upside, you can usually use the funds for almost anything, like consolidating or paying off debt or financing home renovations.

Pros and Cons of a Cash-Out Refinance

A cash-out refinance can give you an injection of cash when you need it, but there are also pitfalls.

Pros

• Large loans available: Cash-out refinance loans use the equity in your home and can amount to a significant sum of money.
• Low rates: Because your home is used as collateral, you might qualify for low interest rates, especially when compared with personal loans or credit cards.
• Possible tax break: You may get a tax break from the IRS if you use the funds for substantial improvements to your home.
• Longer repayment period: If you decide to replace your existing mortgage with a new 15- or 30-year loan, you can stretch out your payments and extend your repayment period.

Cons

• Home as collateral: A cash-out refinance uses your home as collateral for the new loan. Default on your loan and you risk foreclosure.
• Mortgage reset: The cash-out refinance resets the clock on your mortgage so the new loan offsets payments made on your existing mortgage.
• Loan costs: You may pay closing costs and possibly other charges on your cash-out refinance.
• Added interest: If you extend the term of your loan, you will pay more in interest over time.

When to Choose a Cash-Out Refinance

If the interest rate on your cash-out refinance is lower than on your existing mortgage, and you need a little extra cash, a cash-out refinance can make sense. Leveraging the equity in your home and using it to make renovations that add value to your property is also practical. You may even get a tax break if you meet the standards for "substantial improvements" to your home.

A cash-out refinance can allow you to add to an emergency fund for future expenses, pay educational costs or consolidate high-interest debt.

What to Consider Before Tapping Into Your Home Equity

If you own a home but are feeling a bit strapped for cash, you might be tempted to tap into the equity in your home. After all, the average homeowner in the U.S. has $207,000 in home equity, according to a 2022 report from mortgage industry observer Black Knight.

But before tapping into the equity in your home, you'll want to step back and consider the pitfalls of a home equity loan, HELOC or cash-out finance. In essence, you are increasing your debt while reducing your home's accessible equity. If you want to sell your home in the near future, for instance, consider how tapping your home's equity will affect the proceeds from the sale.