Is a HELOC a Refinance & What Are the Differences?

Homeowners frequently consider leveraging their home equity to achieve various financial goals. This equity, representing the portion of a home’s value that is owned outright, can be a valuable resource. Two common methods for accessing this built-up value are a Home Equity Line of Credit (HELOC) and a cash-out refinance.

Understanding a Home Equity Line of Credit (HELOC)

A Home Equity Line of Credit (HELOC) functions as a second mortgage, allowing homeowners to borrow against the equity in their property. It operates much like a revolving credit card, providing access to funds as needed, up to an approved credit limit.

HELOCs typically involve two distinct phases: a draw period and a repayment period. During the draw period, which commonly lasts between 5 and 10 years, borrowers can access funds, repay them, and draw again. Payments during this initial phase are often interest-only, meaning the principal balance may not decrease unless additional payments are made.

Once the draw period concludes, the HELOC transitions into the repayment period, which can extend for up to 20 years. At this point, new withdrawals are no longer permitted, and borrowers must begin making payments that cover both principal and interest on the outstanding balance. Interest rates on HELOCs are typically variable, meaning they can fluctuate based on a chosen index.

Understanding a Cash-Out Refinance

A cash-out refinance involves replacing an existing mortgage with a new, larger mortgage. This process allows homeowners to tap into their home equity by borrowing more than their current mortgage balance, receiving the difference as a lump sum of cash at closing. The new loan then pays off the old mortgage and any associated liens.

With a cash-out refinance, the funds are provided upfront, in contrast to the flexible access offered by a line of credit. This new mortgage typically comes with new terms, including a new interest rate and loan term, which can range from 10 to 30 years. Interest rates for cash-out refinances are generally fixed, providing predictable monthly payments over the life of the loan.

Lenders typically determine the maximum loan amount based on the home’s appraised value and the borrower’s loan-to-value (LTV) ratio, often allowing borrowing up to 80% of the home’s value.

Key Distinctions Between HELOCs and Cash-Out Refinances

A HELOC is a second mortgage that is taken out in addition to the current primary mortgage, allowing the original mortgage to remain in place with its existing terms. In contrast, a cash-out refinance replaces the entire existing primary mortgage with a new one, essentially resetting the loan terms.

A HELOC provides a revolving line of credit, enabling borrowers to draw funds as needed over a specified draw period, much like a credit card. Conversely, a cash-out refinance delivers the borrowed equity as a single, large lump sum at the time of closing. This means interest on a HELOC is only paid on the amount actually borrowed, while a cash-out refinance incurs interest on the entire new, larger loan amount from day one.

HELOCs typically feature variable interest rates that can change over time, potentially leading to fluctuating monthly payments. Cash-out refinances, however, usually offer fixed interest rates, providing consistent and predictable monthly payments for the loan’s duration.

Closing costs for a cash-out refinance are comparable to those of a purchase mortgage. These costs include fees for origination, appraisal, title services, and credit reports. HELOCs typically have lower closing costs, and some lenders may even offer them with no closing costs.

Choosing the Right Option for Your Needs

Selecting between a HELOC and a cash-out refinance depends heavily on an individual’s financial goals and how they intend to use the funds. A HELOC is often suitable for those who need flexible access to funds over time, such as for ongoing home renovations with unpredictable costs or for covering intermittent expenses like college tuition. This option allows borrowers to draw only what is necessary, paying interest solely on the amount utilized, which can be advantageous if the full amount is not needed immediately.

Conversely, a cash-out refinance is generally better suited for homeowners who require a large, one-time sum of money for a specific purpose. This could include consolidating high-interest debt, funding a major home improvement project, or making a significant investment. It is particularly appealing if current mortgage rates are lower than the existing mortgage’s rate, or if the borrower wishes to switch from a variable-rate to a fixed-rate mortgage on their primary loan. Considerations such as current interest rates, the amount of equity available, and the borrower’s comfort with variable versus fixed payments should guide the decision-making process.