A HELOC is a second mortgage that you take out on top of your first mortgage, while a cash-out refinance replaces your old loan. While both of these loan types allow homeowners to access funds for large expenses like debt consolidation, home renovations, or other financial obligations, these two financing options differ in several important ways.
Choosing the right one depends on your specific needs, financial goals, and comfort with the specific loan terms associated with it.
What Is a HELOC?
A home equity line of credit (HELOC) allows you to borrow against the equity in your home, which is essentially the difference between your home’s current market value and the amount you still owe on your mortgage.
HELOCs work similarly to a credit card in that it provides a revolving line of credit and you only pay interest on the amount you actually use.
Key Features of a HELOC:
- Variable Interest Rates: HELOCs usually have adjustable interest rates, which fluctuate based on current market conditions and ultimately affect monthly payments.
- Draw and Repayment Periods: You can borrow money throughout the draw period, which typically lasts between 5 and 10 years, and are only required to pay interest. At the end of the draw period, the repayment phase begins, and this usually lasts for about 10 to 20 years, during which you must pay both the principal and interest.
- Flexible Borrowing: You have the option to borrow as needed, repay, and borrow again as long as you are still within the draw period.
What Is Cash-Out Refinance?
Cash-out refinance is the process of replacing your existing mortgage with a new, larger one and receiving the difference between the two loan amounts in cash. This means that you can take out a new loan for more than you currently owe on your mortgage, and the difference is given to you as a lump sum.
Key Features of a Cash-Out Refinance:
- Fixed or Variable Interest Rates: Cash-out refinances may come with either fixed or adjustable interest rates, though many borrowers usually choose the stability of a fixed rate.
- Longer Loan Terms: Since you are refinancing your current mortgage, you are likely going to reset the clock on your original mortgage term, meaning you’ll be making payments over 15, 20, or even 30 years, depending on the new terms of your loan.
Comparing HELOC and Cash-Out Refinance
Below, we compare HELOCs and cash-out refinances based on several key factors:
1. Loan Structure
- HELOC: A HELOC works more like a credit card because it is essentially a revolving line of credit. This allows you to borrow multiple times up to your approved limit and only pay interest on the current amount borrowed.
- Refinance: Cash-out refinance allows you to receive a one-time lump sum. However, once you have been refinanced, you can no longer borrow additional funds unless you refinance again.
2. Interest Rates
- HELOC: This typically comes with variable interest rates, meaning your interest payments can increase or decrease over time, depending on market conditions. Variable rates usually start lower than fixed interest rates but can be quite unpredictable.
- Refinance: Cash-out refinance typically provides homeowners with a fixed interest rate, ensuring consistent payments over the life of a loan. Fixed rates are more stable and predictable.
3. Cost and Fees
- HELOC: HELOCs usually have lower upfront costs compared to cash-out refinances. However, they may include other payments like maintenance fees, annual fees, or inactivity fees during the draw period.
- Refinance: A cash-out refinance usually has costs similar to your original mortgage, including closing costs, which may range from 2% to 5% of the loan amount. While the upfront costs may be higher, lower interest rates on new mortgages are likely to save you money in the long run.
4. Monthly Payments
- HELOC: During the draw period, you are typically required to make only interest payments on the amount you borrow, however, you can also choose to pay down the principal as well. Once the repayment period begins, your monthly payment must include both the principal and interest.
- Refinance: Your monthly payment will be consistent, assuming you choose a fixed-rate loan. Since you are refinancing your entire mortgage, your payments will include the full loan amount (including the cash-out portion), which will be distributed over your new loan period.
5. Tax Deductibility
- HELOC: According to the IRS, the interest on a HELOC may be tax deductible only if the funds are used to make substantial improvements to your home for energy efficiency, for example, putting a new roof on the property or replacing the HVAC system. If the loan is used for other purposes, the interest rate may not be deductible under the current tax laws.
- Refinance: Similar to a HELOC, the tax deductibility of interest on a cash-out refinance is limited to situations in which the funds are used for home improvements.
6. Flexibility
- HELOC: The biggest advantage you get from a HELOC is the flexibility of borrowing only as needed, repaying, and borrowing again over your approved draw period, which makes it an ideal option for home improvement projects. Most importantly, you have control over how much you borrow at any given time.
- Refinance: Since cash-out refinance is provided as a one-time lump sum, this makes it less flexible than a HELOC. The major advantage you may enjoy is the stability of fixed payments and predictable interest rates.
Choosing Between a HELOC or a Traditional Cash-Out Refinance
Traditional HELOC
You should choose a HELOC if you have ongoing expenses for large home renovation projects, prefer the flexibility it offers, do not mind variable interest rates, and do not want to refinance your entire mortgage.
Traditional Cash-Out Refinance
Choose a cash-out refinance if you need a large, one-time lump sum of cash, prefer the stability of a fixed interest rate, are fine with refinancing your existing mortgage, and don’t mind resetting your mortgage term.
RenoFi Loans: A Smart Alternative
If you need funds to undertake more substantial home renovations, a RenoFi loan or RenoFi cash-out refinance may be the ideal solution.
RenoFi loans allow you to borrow against the after-renovation value of your home, potentially granting you more access to a larger revolving line of credit than a traditional HELOC or cash-out refinance.
Let’s compare an example traditional HELOC with a RenoFi HELOC using a $500,000 home:
- Home price: $500,000
- Downpayment (10%): $50,000
- Current Mortgage Amount: $450,000
In 5 years, let’s say your home value rises by 20% and you’ve paid off $50,000 of your mortgage:
- New home price: $600,000
- Current Mortgage Balance: $400,000
- Your Equity in the house: $600,000 (Home price) - $400,000 (Mortgage balance) = $200,000
Home Equity Line of Credit (HELOC) Terms:
A HELOC may offer 80% of your total equity balance as a second mortgage in the second lien position (second priority of debt that gets paid out after the 1st).
- New home price: $600,000
- Current Mortgage Balance: $400,000
- Your Equity in the house: $200,000
- Example HELOC % of Equity: 80%
- Example HELOC Amount: $200,000 * 80% = $160,000
This means you have a credit line of up to $160,000 that you can access, just like a credit card, that is written against your equity in your house.
RenoFi Home Equity Line of Credit (RenoFi HELOC)
Unlike traditional loans, RenoFi HELOCs allow you to use your home’s after-renovation value, which can be 11x your borrowing power.
Using the same example above:
New home price: $600,000
Current Mortgage Balance: $400,000
Your Equity in the house: $200,000
Example Home Equity Line of Credit (HELOC)
- HELOC % of Equity: 80%
- HELOC Amount: $200,000 * 80% = $160,000
Example RenoFi Home Equity Line of Credit (RenoFi HELOC) Amount:
- After Renovation Value of Your Home: $1,000,000
- Your Equity in the After Renovation Value of Your Home: $1,000,000 - $400,000 = $600,000
- RenoFi Credit Amount: $500,000
By writing a loan against your equity in the after renovation value of your home, RenoFi allows you to borrow a line of credit for renovations against $600,000 versus $160,000. This increases your loan amount from $160,000 to $500,000, allowing you to borrow 3x more than traditional HELOCs for renovations.
RenoFi HELOCs provide a line of credit secured by your current home.
Example RenoFi HELOC Terms:
Years to use credit line: 10 Years
- Interest Only Period: 10 Years
Credit Amount: $500,000
Repayment Term: 15 years
In this example, you’ll have 10 years to use your credit of $500,000. Within those 10 years, just like a credit card, if you borrow against the credit line and pay it back, you will not pay RenoFi anything.
However, for anything borrowed against your credit, that you do not pay off immediately, you will only pay interest during the first 10 years and then interest and principal after year 10.
In addition, RenoFi loans offer:
- No draw periods
- No inspections
- No need to give up your original loan
- Higher borrowing limits
HELOC or Refinance
In the end, the decision between a HELOC and a cash-out refinance comes down to your specific financial needs, goals, and risk tolerance. If you need ongoing access to funds and you are comfortable with a variable interest rate, then a HELOC may be the right choice. However, if you prefer a one-time payout and the stability of fixed payments, a cash-out refinance might be the better option.
If you are a homeowner who is more focused on maximizing your home’s renovation potential, you should consider RenoFi loans, which offer unique advantages for financing large-scale home improvement projects.
You can even borrow, on average, up to 11x more than other financing options. Whatever your choice, ensure that you carefully consider the pros and cons of each option before making a decision.
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