Cash-out refinance or HELOC: which is better for tapping equity?

Cash-out refinance vs HELOC: which is better? If your current mortgage has a low rate, a home equity line of credit (HELOC) is often the better choice, because it leaves that cheap loan alone. A cash-out refinance tends to fit when today’s rates are close to or below your current rate, or when you want one fixed payment.

Both let you turn home equity into cash, and both put your home on the line if you can’t repay. The difference is in how they borrow. One replaces your entire mortgage. The other adds a second loan on top. This guide compares the costs, payments and risks, then works through an example.

How does a cash-out refinance work?

A cash-out refinance replaces your current mortgage with a new, larger one. The new loan pays off the old one, and you get the difference in cash at closing. You end up with one loan, one payment and one interest rate, which applies to the whole balance, not just the cash you took.

Freddie Mac explains that with a cash-out refinance you refinance for more than you currently owe and get part of your equity back in cash. It adds that cash-out loans generally carry a slightly higher rate than a regular refinance, because borrowing more adds risk for the lender.

How much cash can you take out?

Limits are set as a share of your home’s appraised value, called the loan-to-value (LTV) ratio. For a one-unit main home:

• Conventional loans. Freddie Mac’s limit table caps cash-out refinances at 80% of value.
• FHA loans. HUD Mortgagee Letter 2019-11 cut the FHA cash-out maximum to 80% of value.
• VA loans. VA’s cash-out refinance is open to eligible borrowers who will live in the home, and can also refinance a non-VA loan into a VA loan. Ask a VA lender for its limits.

There are timing rules too. Fannie Mae’s Selling Guide generally requires that the first mortgage being paid off is at least 12 months old, and that a borrower has been on title for at least six months. Freddie Mac has similar rules.

How does a HELOC work?

A HELOC is a revolving line of credit secured by your home, separate from your first mortgage. You can borrow up to a credit limit during a draw period, repay, and borrow again. Rates are usually variable. When the draw period ends, you enter a repayment period, and payments often jump.

The CFPB describes how it works:

• Draw period. You can borrow up to your limit, often for about 10 years, using special checks or a card.
• Payments while drawing. Many plans require a minimum payment based on your balance. Some allow interest-only payments, which do not reduce what you owe.
• Repayment period. After the draw period, you repay what you borrowed, often over 10 to 20 years. Payments are often much higher. In some plans the whole balance is due at once as a balloon payment.
• Variable rate. The CFPB HELOC booklet says the rate is usually an index, such as the U.S. prime rate, plus a margin set by the lender. Some lenders start with a low “teaser” rate for a short time.

You keep your first mortgage exactly as it is. That is the main reason HELOCs appeal to homeowners who locked in a low rate years ago.

How do the two compare side by side?

The biggest differences are what happens to your existing mortgage, whether the rate is fixed, and how you get the money. A cash-out refinance gives you a lump sum and resets your whole loan. A HELOC lets you draw only what you need, when you need it, while your first mortgage stays the same.

Both loans usually come with a right to cancel. For loans on your main home that are not used to buy it, the CFPB says you generally have three business days to cancel in writing.

Which one costs less in a real example?

The cheaper option usually depends on the gap between your current mortgage rate and today’s rates. If your existing rate is far below today’s, a cash-out refinance reprices your whole balance at the higher rate. A HELOC charges the higher rate only on the new money, which can save thousands a year.

In this example, the first-year interest on the cash-out loan is roughly $17,900, because the whole $275,000 balance moves to the higher rate. With the HELOC, the interest is about $7,700 on the old mortgage plus about $4,000 on the line, or roughly $11,700. That gap is why many people with low-rate mortgages lean toward a HELOC.

The picture flips if today’s rates are close to or below your current rate. Then a cash-out refinance might lower your rate and give you cash at the same time. For current averages, check Freddie Mac’s weekly Primary Mortgage Market Survey. To judge a refinance on its own merits, see when to refinance your mortgage.

What are the risks of each option?

Both loans are secured by your home, so falling behind can lead to foreclosure. A cash-out refinance can raise your rate on your whole balance and restart your loan term. A HELOC’s variable rate can climb, payments can jump when repayment starts, and the lender can freeze the line.

Cash-out refinance risks

• You may give up a low rate on money you already owed.
• A new 30-year term means paying for longer, which can add total interest.
• Closing costs are generally higher than for a HELOC, and adding them to the loan means paying interest on them for years. Our guide to how much closing costs are explains the typical fees.
• You borrow the full amount on day one, even if your project is spread out.

HELOC risks

• Variable rates mean your payment can rise even if you don’t borrow more.
• Interest-only payments do not reduce your balance, so the jump at repayment can be large.
• The CFPB booklet says lenders can freeze or reduce your line if your home’s value falls or your finances get worse.
• Some plans have annual fees, inactivity fees or early closure fees. Ask before you sign.
• You usually must pay the HELOC off in full when you sell the home.

Which one should you choose?

Choose based on your current rate, how you’ll use the money and how much payment risk you can handle. A HELOC suits low-rate mortgages and costs spread over time. A cash-out refinance suits a single large need, a wish for one fixed payment, or a moment when refinancing also lowers your rate.

A HELOC is often the better fit when:

• Your current mortgage rate is well below today’s rates.
• You need money in stages, such as a remodel paid over several months.
• You can handle a payment that may rise with rates.
• You plan to repay the balance in a few years.

A cash-out refinance is often the better fit when:

• Today’s rates are close to or below your current mortgage rate.
• You want a fixed rate and a single, predictable payment.
• You need one large lump sum right away.
• You plan to stay in the home long enough to earn back the closing costs.

Is the interest tax-deductible?

Sometimes. The IRS lets you deduct interest on home equity borrowing only if you itemize and the money is used to buy, build or substantially improve the home that secures the loan. Money used for a car, a vacation or credit card debt does not qualify, whether it comes from a HELOC or a cash-out refinance.

IRS Publication 936 says that no matter when the debt was taken out, interest on a loan secured by your home is not deductible to the extent the money wasn’t used to buy, build or substantially improve the home. Total qualifying mortgage debt is also limited, generally to $750,000 ($375,000 if married filing separately) for debt taken out after December 15, 2017.

Publication 936 calls a loan used for more than one purpose a “mixed-use mortgage.” For example, a cash-out refinance that pays off your old mortgage and also pays for a car is only partly deductible. Many households take the standard deduction anyway, so taxes rarely decide this choice. A tax professional can confirm your situation.

What to do next

Start with your current mortgage rate, because it often decides the answer. Then price both options with real quotes, and borrow only what you have a clear plan to repay. Equity is a safety net, and keeping some of it in the home protects you if values dip.

1. Find your current mortgage rate, balance and years remaining on your latest statement.
2. Estimate your home’s value and how much equity you can safely tap, staying well under the limits.
3. Get a cash-out refinance Loan Estimate and terms for at least two HELOCs.
4. Compare monthly payments today, payments if HELOC rates rise, and payments once the HELOC enters repayment.
5. If you’re unsure, a HUD-approved housing counselor can review your options at low or no cost. Find one with the CFPB’s housing counselor search.