Cash out refinancing and Home Equity Lines of Credit (HELOC) are two popular ways to access home equity. Both offer unique benefits but differ in repayment terms, structure, and impact on existing mortgages. Thus, understanding the differences between these two options helps determine the most suitable option for specific financial needs.
What is Cash Out Refinancing?
Cash out refinancing involves replacing an existing mortgage with a new loan which is larger than the current balance. The difference between the old mortgage and the new, larger loan is given to the homeowner in the form of a lump sum cash payment. Such an option allows homeowners to tap into their home equity and use the fund for purposes such as home improvement, debt consolidation, and other essential expenses.
In a cash out refinance, the homeowner takes out a new mortgage at a different interest rate, either higher or lower than the original one. The new loan amount covers the old mortgage balance, and any additional amount is provided in cash. While the homeowner benefits from immediate access to cash, the loan resets the repayment period. Such action involves higher monthly payments if the loan amount increases.
Understanding the Basics of HELOC
A Home Equity Line of Credit (HELOC) is a revolving line of credit allowing homeowners to borrow against the equity they built in their home. A HELOC offers flexibility, enabling homeowners to withdraw funds up to predetermined credit limits as needed. Thus, it makes an attractive option for ongoing expenses, such as home improvements, medical bills, or education costs.
In the U.S., HELOCs have a limited period, often lasting 5 to 10 years. It is the time when the homeowner borrows and repays funds when needed. After the drawing period ends, the loan enters the repayment phase. In this phase, the homeowner starts to repay both principal and interest amounts, usually over 10 to 20 years. This interest rate is variable, meaning it can change based on market conditions. Therefore, it is very important to understand the potential for fluctuation in payments.
Key Differences
The key differences between cash out refinancing and HELOC are as follows:
- Loan Terms & Repayment: In a cash out refinance, the loan terms are reset, and the homeowner repays the new mortgage amount over a fixed term, typically 15 or 30 years. On the other hand, HELOC has a limited time of around 5 to 10 years, during which the homeowner borrows and repays funds. A repayment phase with a fixed schedule follows this step. Such differences make HELOC more flexible, but it becomes more complicated to manage later.
- Use of Funds: The funds from cash out refinance are received as a lump sum. It is also used for major one-time expenses such as home renovation, debt consolidation, or large investments. On the contrary, HELOC offers ongoing access to funds, making them ideal for homeowners who need flexibility for expenses arising over time, like home improvement or emergency expenses.
- Risk of Foreclosure: Both cash out refinancing and HELOC are secured by the home, but the risks are a little different. In cash out refinance, failure to repay the new loan leads to foreclosure, as the loan replaces the original mortgage. However, an HELOC is a second lien against the property. It means that if the homeowner defaults, the lender may have to wait until the primary mortgage is paid off before pursuing foreclosure.
- Tax Deduction: The interest on cash-out refinance and HELOC are deductible if the funds are used for qualifying purposes like home home improvements. However, the IRS rules on these changes, and it is important to consult a tax professional to understand the current tax implications of both options.
How Cash Out Refinancing Affects Existing Mortgages?
Cash out refinancing involves replacing the current mortgage with a new, larger loan that incorporates the home’s equity. Such a process directly affects the original mortgage by paying it off and starting a new loan agreement. Here are some ways that it affects the existing mortgage:
- Possible Higher Monthly Payments: Since the new loan is large, the monthly mortgage payments may increase. It happens if the homeowner takes out a significant amount of equity during the refinancing. Therefore, this higher payment affects the homeowner’s monthly budget.
- Closing Costs: Cash out refinancing involves closing costs along with appraisal fees, origination fees, and title insurance. These costs are rolled into the new mortgage, increasing the total amount owed.
- Impact on Tax Deductions: Cash out refinancing sometimes impacts tax deductions, especially if the funds are used for non-qualified purposes. Interest on the new mortgage is still deductible, but the IRS has specific rules regarding how the funds are used.
How HELOCs Provide Flexibility with Home Equity?
HELOC generally functions like a credit card, allowing funds to be drawn as needed within a set limit. Thus, this structure provides borrowers with flexibility in managing expenses, controlling repayments, and adapting to changing financial needs. Let’s find out the ways HELOCs provide flexibility.
- Variable Credit Limits with Revaluation: Some lenders offer revaluation offers, where the credit limit on a HELOC is adjusted upward if the property value increases. Thus providing even more borrowing flexibility.
- Reusable Credit Line: Funds that are paid back during the draw period are borrowed again, much like a revolving credit card. Such a step is completed without needing to reapply for new financing.
- Separate from First Mortgage: HELOCs do not replace the existing mortgage, allowing homeowners to keep favourable original loan terms intact while still accessing their equity.
- Ability to Lock in Fixed Rates on Portions: Some modern HALOCs now offer the option to lock in a fixed rate on portions of balance, combining the flexibility of a credit line with the predictability of a fixed loan.
Conclusion
Choosing between cash out refinance and HELOC depends on financial goals, repayment preferences, and flexibility needs. While refinancing your mortgage offers a lump sum with new loan terms, HELOC provides ongoing access to equity. Therefore, understanding these differences ensures an informed decision aligned with long-term financial stability and homeownership plans.