Home Equity Loan vs. HELOC vs. Cash-Out Refinance

What Is a Home Equity Loan?

A home equity loan is a type of second mortgage that uses the equity in your home as collateral. Most lenders let you borrow up to 75% to 85% of your home's equity.

Example: You owe $300,000 on your mortgage and your home is appraised at $500,000. This means you have $200,000 in equity. This could qualify you for a home equity loan of $150,000 to $170,000.

You receive a home equity loan in one lump sum and repay it in monthly installments, typically over five to 30 years. The interest rate is fixed, so your payments will stay the same throughout the loan term.

Learn more: How Much Equity Can You Borrow From Your Home?

Pros and Cons of a Home Equity Loan

Home equity loans have both benefits and downsides to consider.

Learn more: Debt-to-Income Ratio Calculator

When Should I Choose a Home Equity Loan?

You might choose a home equity loan when:

• You need to cover a one-time expense. A home equity loan can be a good fit when you need a set amount to pay off credit cards or complete home repairs or improvements.
• You want a fixed interest rate. While interest rates on HELOCs and credit cards can vary, a home equity loan offers predictable monthly payments.
• You're seeking a low interest rate. Home equity loans typically have lower interest rates than personal loans or credit cards.

Learn more: Can You Get a Home Equity Loan With Bad Credit?

What Is a HELOC?

Like home equity loans, HELOCs are second mortgages using your home equity as collateral, but they offer a more flexible way to access funds in the form of a revolving credit line. Your credit limit is based on your home's appraised value, your equity and other factors. You can borrow as needed up to your credit limit during the draw period, which usually lasts five to 10 years, and repay only what you borrow.

During the draw period, you make minimum payments on the amount borrowed, sometimes paying only the interest. When the draw period ends, you begin repaying principal as well as interest, generally over 20 years.

HELOCs usually have variable interest rates, so your payments could change over time. In addition, some HELOCs have a balloon payment that requires repaying the entire balance at once.

Tip: Be prepared for significantly higher payments when your draw period ends. Try to repay at least part of the loan principal during the draw period to reduce what you owe.

Learn more: What Is the Draw Period on a HELOC?

Pros and Cons of a HELOC

Consider both the pluses and minuses of HELOCs before applying for one.

Learn more: Myths and Facts About HELOCs

When Should I Choose a HELOC?

You may want to use a HELOC for:

• Home improvements: Using HELOC funds for improvements that add to your home's value could qualify for tax deductions. You can draw from HELOCs in stages, so they're ideal if you're uncertain of a home improvement project's final cost or timeline.
• Debt consolidation: HELOCs typically offer a lower-interest option than personal loans for consolidating high-interest debt.
• Unexpected expenses: If you don't yet have an emergency fund, a HELOC can act as a safety net to cover unexpected costs at a lower interest rate than credit cards.
• Tuition: While federal student loans are typically more affordable options, using a HELOC for college costs could be less expensive than taking out private student loans.

Learn more: Best Ways to Use a HELOC

What Is a Cash-Out Refinance?

A cash-out refinance lets you convert home equity into cash. While home equity loans or HELOCs don't affect your existing mortgage, a cash-out refi replaces that mortgage with a new, larger loan and gives you the difference in cash. You can typically use this cash for any purpose, such as paying off debt or financing home improvements.

You might opt for a cash-out refi if you can get a lower interest rate than your original mortgage, want to adjust your repayment term or want to swap an adjustable-rate mortgage for a fixed-rate one.

You generally need more than 20% equity in your home to qualify for a cash-out refinance. In addition, the amount borrowed (including the new mortgage and the cash you take out) usually can't exceed 80% of your home's value.

Example: You owe $150,000 on a house that's worth $500,000, giving you $350,000 in equity. If you undertake a cash-out refinance, your new mortgage cannot be for more than $400,000 ($500,000 x 80%).

Learn more: Should I Do a Cash-Out Refinance to Pay Off Debt?

Pros and Cons of a Cash-Out Refinance

There are positive and negative aspects to a cash-out refinance.

Learn more: 15-Year vs. 30-Year Mortgage: Choosing the Best Loan

Tip: Rolling closing costs into your new loan amount can be tempting, but it means paying interest on them. Paying closing costs out of pocket saves money in the long run.

When Should I Choose a Cash-Out Refinance?

If you just want to tap your equity, a HELOC or home equity loan will do the job; but if you also want to adjust your mortgage terms, consider a cash-out refi. A cash-out refi may make sense if:

• Interest rates have dropped. If mortgage interest rates are at least 1% lower than when you got your first mortgage, refinancing could make financial sense.
• Your credit score has improved. You might qualify for lower interest rates if your credit score is higher than when you originally got your mortgage.
• You want to change your loan terms. You may want a longer or shorter loan term or hope to switch from an adjustable-rate to a fixed-rate mortgage.
• You plan to finance home improvements. A cash-out refinance can pay off if you use the proceeds for projects that will increase your home's value.

Learn more: When Should You Refinance Your Mortgage?

What to Consider Before Tapping Into Your Home Equity

Before you apply for a home equity loan, HELOC or cash-out refinance, it's important to consider the possible pitfalls.

• Borrowing against your equity reduces your ownership stake in your home.
• If you sell your home with a second mortgage in place, paying off that mortgage will reduce your profits from the sale.
• Taking on more debt could make it harder to manage your financial obligations.
• You could lose your home if you fail to make your loan payments.

Learn more: Reasons Not to Tap Into Home Equity

How to Access Home Equity

If you decide you're ready to tap into your home equity, here's how to do it.

How to Apply for a Home Equity Loan

1. Check your eligibility. To get a home equity loan, you'll typically need a FICO^® Score^Θ of 680 or higher, a DTI of 43% or less and at least 15% to 20% equity.
2. Compare loan terms. Get at least three quotes for home equity loans and compare annual percentage rates (APRs), repayment terms and closing costs.
3. Choose the best loan and apply. You'll typically need W-2s, paystubs, bank statements and proof of homeowners insurance to back up your application.
4. Close on the loan. Review loan documents carefully before signing. It generally takes four to seven weeks to close on a home equity loan.

Tip: To estimate your home equity, check your home's value on real estate websites such as Zillow, Redfin and Realtor.com and subtract your mortgage balance.

How to Apply for a HELOC

1. Check your eligibility. You generally need a credit score of at least 620, at least 20% to 25% equity and a DTI of 43% or less to get a HELOC, although some lenders allow DTIs up to 50%.
2. Compare loan terms. Shop around with banks, credit unions and online lenders to find the best HELOC interest rates and loan terms.
3. Choose the best loan and apply. Have W-2s, paystubs, bank statements and proof of home insurance ready to support your application.
4. Close on the loan. Reviewing your application typically takes a few weeks. If you're happy with the loan agreement, sign it and close on the loan.

Learn more: How to Get a HELOC

How to Apply for a Cash-Out Refinance

1. Check your eligibility. You generally need a FICO^® Score of 620 or more, a DTI of less than 50% and home equity of 20% or more to qualify for a cash-out refinance.
2. Assess your current mortgage. You'll need to know your principal balance, interest rate, remaining term and monthly payment to evaluate loan offers.
3. Compare loan offers. Get quotes from three to five mortgage lenders to evaluate their offers. Use a mortgage calculator to compare loan terms; be sure to consider closing costs too.
4. Choose the best loan and apply. You'll need supporting documents such as pay stubs, W-2 forms, bank statements and proof of home insurance.
5. Close on the loan. This typically takes 30 to 60 days. Read your loan agreement carefully before signing.

Learn more: How to Refinance a Home Mortgage

The Bottom Line

Using equity to increase your home's value can be a wise move, but also poses the risk of losing your home if you default. Personal loans, available for up to $100,000, are an option that won't endanger your home. Personal loans typically have higher interest rates than loans secured by your home, but lower rates than credit cards. No matter what type of credit you're applying for, it's a good idea to check your credit report and credit scores first and take steps to improve your credit if necessary.