HELOC vs cash-out refinance: how they compare

This guide is for homeowners who need money and are thinking about using their home’s value to get it. It compares the two most common ways, the home equity line of credit (HELOC)home equity line of credit (HELOC)A home equity line of credit (HELOC) lets you borrow again and again against the equity in your home: what the home is worth minus what you owe on your mortgage. During the draw period you can take out money up to your credit limit, usually with special checks or a card. When that period ends you can no longer borrow and you enter the repayment period, when payments are often much higher; sometimes the whole balance is due at once. It usually has a variable interest rate. If you do not repay it, you could lose your home.See the full definitionClose and the cash-out refinancecash-out refinanceIn a cash-out refinance you take out a new mortgage for more than you still owe and receive the difference in cash. It is a way to borrow against the equity in your home. Under Fannie Mae's rules, the new loan is a first mortgage on the same home that pays off any existing mortgages, or a new mortgage on a home that is owned free and clear. According to FHFA's Office of Inspector General, Fannie Mae and Freddie Mac place no restrictions on how the cash is used. Your debt goes up and the home remains the collateral.See the full definitionClose, with their costs, their risks and what the law gives you.

To cancel a HELOC or a refinance on your principal home

3 business days⁷

After you receive the HELOC disclosures, before you can be charged a nonrefundable fee

3 business days⁵

To get your money back if you cancel in time

20 days⁶

Of the adjusted value, the most an FHA cash-out refinance can lend

80%⁹

What they have in common: your home is the collateral

Both options lend you money against your home equityhome equityHome equity (or equity) is what your home is worth today minus what you still owe on the mortgages on it. You can borrow against that equity: with a home equity loan, which you receive as a lump sum and which usually has a fixed rate; with a HELOC; or with a cash-out refinance. In all of these the home is the collateral and, if you do not repay, the lender could take it. With a reverse mortgage, the balance grows each month and your equity goes down.See the full definitionClose: what your home is worth minus what you owe on your mortgage.¹ And with both, your home is at risk.⁴

The CFPB puts it plainly: only consider a HELOC if you are confident you can keep up with the payments, because if you fall behind or can’t repay on schedule, you could lose your home.¹ HELOCs and home equity loans are second mortgagessecond mortgageA second mortgage (or junior lien) is a loan you take out using your home as collateral while you still have another loan secured by it. Home equity loans and HELOCs are common examples. It is called "second" because, if you stop paying and the home is sold to pay the debts, this loan is paid after the first one; if there is not enough money, the second lender may not get everything it is owed. That is why it often has a higher interest rate. It adds to your total debt and, if you cannot repay it, you could lose your home.See the full definitionClose: if the home is sold to pay the debts, they are paid after the first mortgage, which is why they often carry higher rates. And taking one on adds to your total debt.³

Example with real numbers

How much equity you have in your home

A calculation in words, with your own numbers: A is what your home is worth and B is what you owe on your mortgage.

A: Your home's value (from an appraisal)

A

B: What you owe on your mortgage

B

Your home equity

A − B

Maximum FHA cash-out loan (80% of the adjusted value)

80% of A

Cash possible with FHA, before closing costs

80% of A − B

Equity is the value minus what you owe.¹ The 80% is FHA's limit for a cash-out refinance.⁹ Other lenders and programs use other limits, and closing costs come out of what you receive.

Run it with your numbersClosing costs

How a HELOC works

A HELOC is an “open-end” line of credit: you borrow repeatedly against your home’s value.¹ It works in two stages.

The life of a HELOC

1. 1. You apply for the HELOC

   At application

   You receive the disclosures and the CFPB booklet; no nonrefundable fee can be charged until three business days later.⁵

2. 2. The line opens

   Three business days to cancel

   You can cancel in writing, and the fees you paid are returned.⁴

3. 3. Draw period

   Could last 10 years, for example

   You draw up to your limit with special checks or a card, and make minimum payments.¹

4. 4. Repayment period

   When the draw period ends

   You can no longer draw; payments are often much higher, or you must repay everything at once.¹

5. 5. If you sell the home

   At any time

   You generally must pay off the HELOC in full immediately.⁴

The draw period. You can generally spend up to your limit at any time during this period, which could last 10 years, for example. Some plans require a minimum draw each time or a minimum balance, and many have minimum payments based on what you owe.¹ Others allow interest-only payments during the draw period.⁴

The repayment period. When the draw period ends, you can no longer take money out. The lender may set a schedule to repay the full balance, and payments are often significantly higher. In some cases you must repay everything you owe as soon as this period begins.¹ That large payment is called a balloon paymentballoon paymentA balloon payment is a large, one-time payment at the end of the loan term, higher than the payments before it and sometimes much higher. On the Loan Estimate, "Balloon Payment" means any payment that is more than two times a regular payment. Loans with a balloon payment usually have shorter terms and lower monthly payments that do not pay off the whole debt. If you cannot make the final payment, you may have to refinance or sell the home, or face foreclosure. With limited exceptions, a Qualified Mortgage (QM) cannot have a balloon payment.See the full definitionClose, and if you can’t pay it in full, you could lose your home.⁴

The rate. HELOCs usually have a variable rateadjustable-rate mortgage (ARM)An adjustable-rate mortgage (ARM) is a loan whose interest rate can change, usually in step with a market index. It often starts with a fixed rate for an initial period (for example, the first few years) and then adjusts at set intervals, so your payment can go up or down. The contract sets caps on how much the rate can rise at each adjustment and in total. Before accepting one, check on the Loan Estimate how high your payment could reach and whether you could afford it.See the full definitionClose, so your payment can change from month to month. Some let you move part of the balance to a fixed rate, which is usually higher but more predictable.¹ A variable rate has two parts, the index and the margin, and some lenders offer a very low introductory (“teaser”) rate for a short time.⁴

The costs. Some lenders waive up-front costs and others charge them: for example, an appraisalhome appraisalAn appraisal is a written document that gives a professional appraiser's opinion of how much a property is worth. The lender orders it before approving the mortgage, because the home is the loan's collateral and the lender does not want to lend more than it is worth. If the appraisal comes in below the price you agreed, the bank bases the loan on the lower value and you will have to cover the difference, renegotiate the price or walk away if your contract allows it. An appraisal is not an inspection: it measures value, not the home's condition.See the full definitionClose, an application fee that might not be refunded if you are turned down, and closing costs such as the title search and recording. If you sell your home, you generally must pay off the HELOC in full immediately. And the terms of the line may prohibit renting out your home.⁴

How a cash-out refinance works

Here you replace your current mortgage with a bigger one and take the difference in cash.⁴ The money is not limited to specific purposes.⁹ With FHA, the new loan cannot exceed 80 percent of the home’s adjusted value, and the property must have at least six months of payments on the current loan.⁹

The advantage is that you keep just one mortgage payment. The disadvantages, according to the CFPB booklet: closing costs are generally higher, it may take longer to pay off your mortgage and the rate may end up higher than your current mortgage’s.⁴ VA warns that closing costs can add up to thousands of dollars and says to understand how the new loan compares with your home’s value.¹⁰ If a lender offers to do it “at no cost,” it covers the costs with a higher rate or adds them to the loan, and a larger loan raises your payments and reduces your equity.¹¹

For a cash-out refinance you receive a Loan EstimateLoan EstimateThe Loan Estimate is a three-page form you receive from the lender within days of applying for a mortgage. In the same format at every bank, it sums up the terms of the loan being offered: amount, interest rate, whether the payment can change, the estimated monthly payment with taxes and insurance, the itemized closing costs and how much cash you need at closing. Because every lender uses the same form, it lets you compare offers side by side. It commits you to nothing: requesting one is not accepting the loan.See the full definitionClose, as with any mortgage; for a HELOC you do not: you receive Truth-in-Lending disclosures.⁸ The refinancing guide explains closing costs and how to work out how many months it takes to earn them back.

Side by side

HELOC and cash-out refinance

Line of credit

HELOC

• You draw as needed during the draw period.¹
• Almost always a variable rate: the payment can change monthly.¹
• It is a second mortgage: your total debt grows.³
• If you sell, you generally pay it off in full immediately.⁴

A new, bigger mortgage

Cash-out refinance

• You get the difference at once and keep one payment.⁴
• Variable or fixed rate.⁴
• Closing costs are generally higher.⁴
• With FHA, up to 80% of the adjusted value.⁹

With both, your home is the collateral: get offers in writing and compare the total cost, not just the monthly payment.⁴²

There is a third option similar to a HELOC: the home equity loan. It gives you the money as a lump sum, usually at a fixed rate, and it is also a second mortgage: if you can’t repay it, the lender could foreclose on your home.²

What the law gives you on a HELOC

Regulation Z, which carries out the federal Truth in Lending Act, sets clear rules for HELOCs:⁵

• Information from the start. The lender must give you the HELOC disclosures and the CFPB booklet when it gives you an application.
• No nonrefundable fees up front. No one may charge a nonrefundable application fee until three business days after you receive those disclosures and the booklet.
• If terms change. If a term changes before the line opens (other than index movement) and you decide not to open it, all fees must be refunded.
• The rate changes only with a public index. The lender cannot change the rate on its own: it must use an index it does not control and that the public can see.
• They can’t demand the full balance for any reason. Only for fraud or material misrepresentation, failure to make the payments, or something you do that harms the collateral.

What the lender can do is stop extending credit or lower your limit while your home’s value is significantly below the appraisal for the line, while it reasonably believes you can’t pay because of a material change in your finances, or while you are in default of a material obligation.⁵ If that happens, the CFPB booklet suggests talking with the lender to find out the reason.⁴

The HELOC lender must also give you a list of HUD-approved housing counselorsHUD-approved housing counselorA HUD-approved housing counselor works at an agency HUD has approved to provide housing counseling: independent, expert advice customized to your situation about buying a home, renting, a missed mortgage payment, a foreclosure or credit problems. The agencies usually charge little or nothing; many serve in Spanish and offer the homebuyer education course several assistance programs require. They are not lenders or real estate agents and sell you nothing. Your county page lists the official agencies with phone numbers.See the full definitionClose in your area, who offer free or low-cost help with budgeting and money.⁴

Taxes: when the interest is deductible

According to IRS Publication 936, you can no longer deduct interest on a loan secured by your home to the extent the money was not used to buy, build or substantially improve your home. And to deduct mortgage interest you must itemize deductions on Schedule A of Form 1040.¹⁴ If you want someone to review your return, an IRS VITAVITA (free tax preparation)VITA (Volunteer Income Tax Assistance) and TCE (Tax Counseling for the Elderly) are IRS programs that offer free basic tax return preparation by IRS-certified volunteers. They are meant for people with moderate income, people with disabilities and limited-English speakers; TCE focuses on people sixty and older. The IRS sets no program-wide income limit, but individual sites may set their own. Many sites serve in Spanish and help with ITIN applications and renewals. Filing taxes every year builds the record lenders ask for.See the full definitionClose site is one option.

Before you borrow against your home

The CFPB urges caution about using home equity to pay off higher-interest debts: you are not really paying them off, just replacing one loan with another, with your home as collateral. It also warns about trading short-term debt for long-term debt, which can mean paying interest for many more years.³ Before using a home equity loan to pay off debts, the CFPB suggests talking with a credit counselor about alternatives that do not put your home at risk.²

In its booklet, the CFPB compares a HELOC with other money sources. With a personal line of credit or a credit card your home is not at risk, although the rate is higher.⁴ And if you plan to refinance your first mortgage later, keep in mind that with a HELOC you may need its lender’s permission, or to pay it off first.¹³

If the money is for a repair, also read the contractor scams guide: some scammers offer to “arrange the financing” along with the work.

If this is you

You need money for a repair

A HELOC lets you draw as the work is paid for; a cash-out refinance gives you everything at once with one payment.¹⁴

You are 62 or older

A reverse mortgage (HECM) is another way to use your home's value, with its own rules. See the reverse mortgage guide.⁴

You want to roll your debts into one

The CFPB warns that this does not really pay them off: you swap them for another debt with your home as collateral.³

You already struggle to pay the mortgage

Another debt on your home puts it at more risk.³ Start with the can't pay my mortgage guide.

Costly mistakes

• Mistake: Looking only at a HELOC's introductory rate.

  Instead: Ask about the index, the margin and how high the variable rate can go.⁴

• Mistake: Not planning for the repayment period.

  Instead: Work out the payment after the draw period ends: it is often much higher.¹

• Mistake: Comparing only the monthly payment.

  Instead: Compare the fees and the total cost of each offer.²

• Mistake: Choosing a cash-out refinance without looking at closing costs.

  Instead: They are generally higher than for a HELOC; ask for the Loan Estimate.⁴⁸

• Mistake: Using home equity to pay off credit cards without changing habits.

  Instead: Remember that you are swapping one debt for another, with your home as collateral.³

• Mistake: Paying a nonrefundable fee the day you apply.

  Instead: The law does not allow it until three business days after you receive the disclosures.⁵

What to do this week

1. Work out your equity: what your home is worth minus what you owe on your mortgage.¹
2. Write down what you need the money for and how long you expect to take to repay it; compare that with the draw and repayment periods.¹
3. Ask for the disclosures on at least one HELOC and the Loan Estimate for a cash-out refinance, and compare fees, rate and total cost.⁵⁸
4. Use the mortgage calculator to see your payment with a bigger loan, and the closing cost calculator to estimate what you would pay.
5. Before you sign, write down the deadline to cancel.⁷
6. If you want to go over your options with someone, a HUD-approved housing counselor gives independent advice, often free or at low cost.¹⁵ Find one through the HUD-approved counselors guide.