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Cash-Out Refinance vs. a Home Equity Loan or HELOC: Which Is Best for You?

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If you want to make home improvements or pay off high-interest debt, you might be considering a cash-out refinance versus a home equity loan or HELOC. Knowing how each of these equity-tapping loans work will help you make a cost-effective choice that best helps you reach your financial goals.

Cash-out refinance vs. a home equity loan

A cash-out refinance replaces your current mortgage with a new home loan with a larger loan amount, allowing you to pocket the difference in cash. Current low cash-out refinance rates may make this option ideal for snagging the lowest monthly payment.

With a home equity loan, though, you’ll take out a second mortgage on top of your primary loan, meaning you’ll make two house payments.

What’s the same

With a cash-out refinance and a home equity loan, you’ll:

  • Verify your income, credit and assets
  • Be able to roll closing costs into your loan amount
  • Borrow all the money in a lump sum
  • Typically have a fixed payment schedule
  • Choose a fixed interest rate
  • Pay 2% to 6% of your loan amount toward refinance or home equity loan closing costs
  • Face foreclosure if you default, or fail to repay the loans
What’s different

With a cash-out refinance, you’ll:

  • Have a lower rate than a home equity loan
  • Be able to choose a longer term (up to 30 years) to keep your payments low
  • Be limited to borrowing up to 80% of your home’s value in most cases
  • Be able to borrow money with a lower credit score
  • Have access to government-backed and conventional loan programs
  • Have just one monthly mortgage payment

With a home equity loan, you’ll:

  • Leave the balance of your current mortgage alone
  • Receive a higher interest rate than a cash-out refinance
  • Pay the loan off within five to 15 years
  • Need a higher credit score for approval
  • Have two monthly housing payments

Cash-out refinance vs. a HELOC

A home equity line of credit (HELOC) works more like a credit card than a regular mortgage. You won’t have a fixed payment, your payments aren’t made on a set amortization schedule and you don’t receive your funds in a lump sum.

What’s the same

With a cash-out refinance and HELOC, you’ll:

  • Need to verify your income, credit, income and assets
  • Be able to roll closing costs into your loan
  • Potentially lose your home to foreclosure if you default
What’s different

With a cash-out refinance, you’ll:

  • Need to take out a new loan if you want to tap more equity
  • Avoid any prepayment penalties or annual fees
  • Make set principal and interest payments for the life of the loan
  • Make only one monthly housing payment

With a HELOC, you’ll:

  • Have a draw period of up to 10 years to tap and pay off equity as needed
  • Be able to use the credit line and make payments only on the amount you use
  • Have an adjustable rate that could result in unpredictable monthly payments
  • Have the option to make interest-only payments during the draw period
  • Pay the balance off in fixed installments at the end of the draw period
  • Face potential prepayment penalties, annual fees and ongoing account charges
  • Make two monthly housing payments

How to decide which loan is best for you

Which is better: a cash-out refinance or a home equity loan? What about a HELOC versus a cash-out refi? We compare the three options below:

A cash-out refinance is best for: A home equity loan is best for: A HELOC is best for:
The lowest possible payment Smaller loan amounts The lowest possible payment (during the draw period)
Lower credit scores Higher credit scores Higher credit scores
A fixed, stable monthly payment A fixed, stable monthly payment Unpredictable funding needs
A fixed interest rate Borrowers with a first mortgage they want to leave alone Access to funds as needed
Borrowers with higher debt compared to their income Borrowers with lower debt compared to their income Borrowers with lower debt compared to their income

 

Qualifying for a cash-out refinance vs. a home equity loan vs. a HELOC

Cash-out refinance qualification requirements

There are three cash-out refi programs to choose from: conventional cash-out refinance, FHA cash-out refinance and VA-cash-out refinance loans.

Conventional cash-out refinance. You’ll need a credit score of at least 620 and a debt-to-income (DTI) ratio of 45%, with some exceptions up to 50%. You can borrow up to 80% of your home’s value without paying for private mortgage insurance (PMI).

FHA cash-out refinance. The Federal Housing Administration (FHA) will insure cash-out refinance loans up to 80% of your home’s value with a score as low as 500, although some FHA lenders may set their minimums higher. FHA-approved lenders may approve DTI ratios above 50%, but you’ll pay hefty upfront and monthly FHA mortgage insurance premiums even if you have 20% equity.

VA cash-out refinance. Military borrowers can tap up to 90% of their home’s value with a cash-out refi. The U.S. Department of Veterans Affairs (VA) guarantees loans without a minimum credit score although most lenders require at least 620. The recommended DTI ratio is 41%, but some exceptions may be allowed. A VA funding fee ranging between 2.3% and 3.6% of the loan amount may be charged unless the borrower is exempt because of a service-related disability.

Home equity loan requirements

You’ll typically need a credit score of at least 740 to get your best rates on a home equity loan, but you may qualify with a score as low as 620. The DTI ratio is typically capped at 43%, but some lenders may allow a DTI up to 50%.

Although home equity loans are usually limited to 85% of your home’s value, according to the Federal Trade Commission (FTC), some lenders may allow you to borrow more. Home equity loans don’t require mortgage insurance if you borrow more than 80% of your home’s value.

HELOC requirements

Qualifying requirements for a HELOC are similar to a home equity loan. A valuable HELOC tip from the Consumer Financial Protection Bureau (CFPB): If your home’s value drops significantly, your lender may freeze future charges or reduce how much equity you can access.

 

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