Cash-Out Refinance vs. HELOC: What’s the Difference?
If you’ve built equity in your properties, you may be eligible to cash it out and use it for other purposes.
Using the equity in your investment properties is a great way to fund home improvements, expand your real estate portfolio, or consolidate debt.
Many investors have two options when tapping into a home’s equity: a cash-out refinance and a home equity line of credit (HELOC). Both loans provide access to home equity, but in different ways.
Here’s everything to know to compare the cash-out refinance to HELOC to determine the best option.
Cash-Out Refinance vs HELOC: Overview
Comparing a HELOC vs. cash-out refinance is important when deciding which makes the most sense, given your goals. Each loan option has pros and cons.
A cash-out refinance is better when you have a one-time expense and need funds in a lump sum. On the other hand, a HELOC is better when you have ongoing expenses or are unsure of the total amount needed for your goals.
Here’s how they compare.
A cash-out refinance is a refinance of the first mortgage on the property.
The new mortgage pays off the mortgage loan you already have, but has a higher principal balance. A cash-out refinance combines the funds needed to pay off the original mortgage, plus the home’s equity you can cash out.
The cash-out refinance is a first mortgage on the property. You receive the funds in one lump sum at the closing and don’t have access to more equity unless you refinance again.
Cash-out refinance loans have a fixed interest rate that doesn’t change throughout the term, keeping your monthly payment the same. You also pay principal and interest payments, starting with your first payment.
Process and benefits
The cash-out refinance process is similar to any financing you borrowed to purchase the property. The cash-out refinance replaces the first mortgage on the property.
Suppose you have a second mortgage on the property. In that case, you may need to include it in the mortgage refinance or petition the lender to subordinate it.
However, most lenders will require you to pay off the second mortgage first; it depends on your property equity. You must prove you have the income, assets, and equity to qualify for the refinance of this entirely new loan.
To get approved, you must prove the following:
- Good credit history: Lenders have different credit score requirements, but you’ll need a 660+ credit score on average. Your credit history also should be free from late payments or other negative credit events, such as bankruptcy or foreclosure.
- Good debt-to-income ratio: Your income versus debts tells lenders how much of your income you’ve committed to debt. The higher your income and the lower your debts, the easier it is to get approved, especially if you own multiple properties. Most lenders look for a DTI of 50% or less, but this varies.
- Home equity: Lenders usually require investors to leave 20% to 35% of the investment property’s equity untouched. This leaves you up to 70% to 75% of the home’s value to borrow from, including the amount already owed on your first mortgage.
- Reserves: Many lenders require investors to have as much as six monthly payments in a liquid account, such as checking or savings. This ensures you can pay the mortgage even if you have vacancies or your tenants don’t pay the rent.
Like any financing option, you should consider the pros and cons when using a cash-out refinance on your investment property. These include:
- Single loan: You don’t have to worry about multiple mortgage payments on the same property, making it easier to handle your finances and determine your profit and loss. You have a new loan that replaces the existing mortgage.
- Fixed interest rates: Cash-out refinance loans are the primary mortgage on the property and usually have fixed interest rates, so you don’t have to worry about your payments changing.
- Potentially tax deductible: If you use the funds to purchase, build, or substantially renovate a property, the interest may be tax deductible.
Considerations and drawbacks
Like any home loan, there are factors to consider, including the downsides of a cash-out refi.
The most important factor is that it’s not as easy to qualify for a cash-out refinance as it might have been to purchase the property. Since you’re borrowing a larger home loan amount with a cash-out refi, lenders take more risk and have stricter underwriting guidelines.
Lenders won’t let you borrow 100% of the home’s value to protect themselves. You must leave some of the equity untouched; with investment properties, this often means 30% to 35% or more.
In addition to the considerations, evaluate the downsides of a cash-out refi, including:
- Higher cost: Cash-out refinance loans have closing costs similar to those you paid when you bought the property. These closing costs increase the borrowing cost and should be a factor when deciding which loan is best.
- Higher interest rates: Lenders often charge higher interest rates on investment properties and cash-out refis, making your interest rate on cash-out refinances higher than traditional loan terms. A higher interest rate means a higher payment, so make sure you can afford it.
- Risk of losing collateral: Borrowing a higher loan amount means you’re at a higher risk of losing the property if you don’t make the payments. Ensure you can afford the monthly payment, including having reserves to handle any vacancies.
HELOC (Home Equity Line of Credit)
A HELOC is a second mortgage on the property. It’s like turning the property’s equity into a credit line or credit card.
You decide how you receive the funds. You can receive the entire amount as a line of credit or a portion of the funds at the closing and the remainder in the line of credit.
When comparing a HELOC vs. cash-out refi, you must understand that a HELOC is a second mortgage. If you still have a primary mortgage, you’ll have two mortgage loan payments, but a HELOC monthly mortgage payment works differently.
When you borrow funds from a HELOC, you must make interest payments on the amount withdrawn.
However, unlike a cash-out refinance, you don’t have to make principal payments if you don’t want to yet. This may make the payment more affordable for now. However, like a credit card, it will accumulate more interest the longer the balance remains unpaid.
Process and benefits
The HELOC process is different from a cash-out refi because you have a credit line you can access. The draw period typically lasts 10 years, allowing you to withdraw up to your limit to use the funds however you want, and require only interest payments.
The repayment period begins when the draw period ends, usually after 10 years. During the repayment period, you cannot withdraw funds and must make principal and interest payments to pay the loan off within the loan term, typically 20 years.
Like a cash-out refinance, you must qualify for a HELOC. Each lender has different requirements, but here are the basics:
- Great credit scores: Most HELOC lenders require a higher credit score than cash-out refis. Expect to need a credit score of 680 or higher. Some lenders want a score of at least 700.
- Good debt-to-income ratio: Your DTI tells lenders if you can afford the monthly payments. This is especially important with a HELOC because you can continually withdraw funds up to your credit line’s limit.
- Home equity: You may be able to secure a HELOC with a loan-to-value ratio as high as 80%. This varies by lender and what you can afford.
Understanding the pros and cons of a HELOC on your investment property can help you decide if it’s the right choice, such as:
- Long draw period: A HELOC provides access to the home equity for a long time. You don’t have to withdraw all the funds at once, paying interest on an amount you aren’t using yet.
- Lower payments: If you make interest-only payments, the payments are lower. If you can afford higher payments, it’s worth paying the principal and interest. However, you can make the lower payments if needed.
- Higher loan-to-value ratio: HELOC lenders may allow slightly higher LTVs, letting you borrow up to 80% of the property’s value.
Considerations and drawbacks
There are important factors to consider when deciding whether to use a HELOC to access your property’s equity. The most important factor is the risk of getting in over your head.
Knowing you can cash out the property’s equity can make it tempting to use the funds for something other than improving your real estate portfolio or the property itself. Ensure you’re using the equity line of credit to benefit your financial situation, not worsen it.
Some lenders also have stricter requirements to get a HELOC. Because it’s a second loan, HELOC lenders are in a more challenging position if you don’t make your payments. Many lenders require higher credit scores and lower debt-to-income ratios to compensate for the risk.
Here are some of the drawbacks of a HELOC vs. cash-out refinance:
- Harder to find: Many lenders don’t offer HELOCs on rental properties, so you may have to do more legwork to find the right lender and loan terms.
- Higher fees: HELOCs often have different fees, such as annual or early termination fees. For example, if you pay off the loan within three years, you may pay an early termination fee.
- Higher rates: You may pay higher interest rates because of the higher risk a HELOC poses to lenders.
Cash-Out Refinance vs HELOC: Key Differences
There are key differences when comparing the cash-out refinance vs. HELOC to consider.
Cash-out refinance loans require monthly principal and interest payments, usually 30 to 45 days after closing. The payment depends on the amount borrowed and the loan terms.
HELOCs require only interest payments on the amount borrowed. You can make principal and interest payments to repay what you borrowed, but it’s not required until the repayment period begins.
Cash-out refinance loans usually have a fixed interest rate that doesn’t change for the life of the loan.
This means your payment doesn’t change unless you pay your real estate taxes and homeowners insurance as a part of the loan. If those payments change, so does your mortgage loan payment.
HELOCs have a variable interest rate. This means the interest rate changes with the market. You’ll have less predictable monthly payments and may pay more interest in some months than others.
Cash-out refinance loans have a fixed length of 10 to 30 years. The loan terms depend on what you qualify for and can afford.
The longer you borrow money, the lower your monthly payments, but the more interest you’ll pay because you have an outstanding mortgage balance for a longer time.
Home equity lines have a draw period and a repayment period. Most lenders allow a draw period of 10 to 15 years and a 10-to-20-year repayment period.
Which Is Right for You?
Understanding the pros and cons of a cash-out refinance vs. HELOC is important when deciding which is right for you.
Consider why you need the funds, how much cash you need, the repayment terms you can afford, the closing costs, and interest rates. Determine if you need the funds for one-time use or if you’ll need access to ongoing funds, such as for property renovations.
Keep in mind that you can typically borrow up to 80% of the home’s value with a HELOC and 70% to 75% with cash-out refinancing.
Choosing between a cash-out refinance and HELOC is a big decision. Decide how you want to use the funds and if you want to pay off your current mortgage loan.
HELOCs are second mortgages that don’t affect the primary mortgage but have variable interest rates, making it a less predictable option. Consider each option’s benefits and drawbacks and the closing costs when choosing the right loan for your rental property.
Which option typically offers better interest rates?
Cash-out refinancing offers a fixed-rate loan, which may initially mean a higher interest rate. Because HELOC rates are variable interest rates, you can’t predict how much you will pay. Initially, they may be lower than a cash-out refi, but can increase throughout the loan’s term.
How does each option impact my existing mortgage?
Cash-out refinances pay off your existing mortgage loan. You will no longer have the rate and terms you obtained when you bought the property, but will only have one loan to handle. A HELOC is a second mortgage loan and doesn’t affect your first mortgage.
Are there any restrictions on how I can use the funds obtained?
Neither the cash-out refinance nor the HELOC dictates how to use the funds. You are free to use them however you want. As long as you make your monthly payments, the property isn’t at risk.
Can I get both a cash-out refinance and a HELOC?
You may be able to get a cash-out refinance and HELOC at different times, but not simultaneously. The largest determining factor is the amount of equity in the home, along with your credit scores and debt-to-income ratio, to prove you can afford the loans.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.