Whether you’re planning a major purchase, want to make some home improvements or need to cover a large medical bill, tapping into the equity in your home can be one of the most cost effective solutions. Borrowing against the value of your home is a secured form of finance, hence you can access some of the lowest borrowing rates on the market. Additionally, you can spread the costs across a longer period to make them more affordable. But, which method offers the best value? Should you consider a HELOC or cash out refinancing.
The HELOC Basics
A HELOC or home equity line of credit is a type of home loan that allows you to borrow money against the equity built up in your home. The HELOC is a form of a second mortgage unless you have completely paid off your first mortgage.
The HELOC works a little differently compared to a standard home loan. Rather than receiving a lump sum and starting repayments, it is a little more like a credit card. You will have an agreed line of credit amount and you can access and use the funds as you like, within a certain time frame. This provides greater flexibility, as you can draw down the funds when you need them, rather than having them sitting in an account while you make repayments.
Most HELOCs have a separate period for borrowing and repayments. The first period, which is also referred to as the draw period, is when the line of credit is opened and the funds are available for use. In this period, you can borrow as you need, making interest only or the minimum agreed repayments on the outstanding debt.
When the draw period ends, you will enter the repayment period. At this stage, you will no longer have access to the line of credit and you will be required to start making monthly payments to cover both the interest and principal balance.
The specific length of these periods can vary, as it depends on the loan details, but it may be possible to extend the draw period with a HELOC refinancing deal.
To qualify for a HELOC, you will need to have a reasonable amount of equity in your home. Financial institutions have minimum equity requirements, but very few will allow you to leverage 100% of your home equity.
For example, if the lender imposes a 80% rule on HELOC applications and your home is valued at $500,000, you could have a maximum debt of $400,000. However, if you have an existing mortgage, the outstanding balance would need to be taken into account. So, in this example, if your existing mortgage balance is $200,000, you could arrange a HELOC for $200,000.
Lenders will also assess your credit score and debt to income ratio. Typically, lenders require a credit score of at least 680 to qualify for a HELOC, and a maximum debt to income ratio of 43%, but there are lenders who are more flexible, but others who have more stringent requirements. Debt to income ratios are calculated as a percentage with the total of your monthly payments divided by your monthly income.
Pros and Cons of HELOCs
Pros
- You can draw funds as and when you need them up to the agreed limit, so you don’t borrow too little or too much
- The line of credit remains open until the draw period ends, so you can easily access additional funds
- Typically, closing costs are lower compared to refinancing
- Generally, there is the option to make interest only repayments during the draw period, to lower your monthly costs.
- If your existing mortgage has a lower rate than you would access today, a HELOC means you only pay the higher rate on the additional borrowing.
Cons
- More complicated payment structure, as you will need to manage two monthly repayments including shifting from interest only payments in the draw period to full repayments in the repayment period.
- As the HELOC does not impact your existing mortgage, you cannot change the terms of your current mortgage deal. If Rates have dropped since you took out your current mortgage, you will not be able to lock in a lower rate on your home loan.
Cash Out Refinancing
Cash out refinancing allows you to take on a larger mortgage to access the equity in your home. Rather than a second mortgage, which involves having a second home loan with its own separate monthly repayment, a cash out refinancing package means that you pay off the existing mortgage and replace it with a new one.
This process allows you to refinance to a higher loan amount to take equity from your home. You can choose to keep the same home loan term, which would increase your monthly repayments or it may be possible to extend the term, to make the monthly payments more affordable.
The cash out refinancing procedure is similar to what you went through for your primary mortgage. You will need to choose a lender, apply, provide the supporting documentation and if you’re approved, your lender will clear your existing mortgage and you’ll receive the funds difference.
To access this type of refinancing, you will need to have sufficient equity in your home and your new lender will check your credit and your debt to income ratio. Generally, you will need a credit score of at least 620 and a debt to income ratio of 50% or less. However, if you access VA or Federal Housing Administration (FHA) loans, there are more flexible requirements.
Pros and Cons of Cash Out Refinancing
Pros
- One monthly repayment rather than needing to make payments on your existing mortgage and a secondary loan
- Opportunity to replace a higher rate mortgage with a lower interest home loan, if you can qualify under the current conditions.
- Option to restructure your primary mortgage terms to lower your current monthly repayments.
Cons
- You may borrow more than you need, which would result in excessive interest expenses
- You may borrow less than you need, so you would need to source additional loan products to meet your requirements
- Closing costs are likely to be higher compared to a HELOC, which would mean it takes longer to reach the point where savings outweigh the costs
- Increasing the total mortgage debt amount could extend the time it takes to completely pay off your home.
- If rates have increased since you took out your original mortgage, you could end up paying a higher rate on the entire new mortgage amount, not just the additional borrowing.
Key Similarities Between a HELOC and Cash Out Refinancing
Both these financial products are designed to allow you to access the equity you have accumulated in your home. They provide a way to convert this equity into accessible funds. There are no restrictions on how you use the funds, so you can use them for home improvements, making a large purchase, paying a large bill or even debt consolidation. Since the finance is secured on your home, you can access lower interest rates, particularly compared to unsecured loans or credit cards. Additionally, if you itemize your deductions and plan on specifically using the funds to improve your property, you can claim a tax deduction on the interest.
Some Other Similarities
- Similar application process including home valuation and qualification criteria
- Potential for losing your home if you do not adhere to the repayment agreement
- An initial hit to your credit score when the new debt is recorded
- Retained equity requirements as most lenders require that you retain a minimum of 15 to 20% equity in your home.
Key Differences Between a HELOC and Cash Out Refinancing
While there are a number of similarities, there are some important differences that will help you to determine which is the best option for you.
The most obvious difference is how the loan is structured. Cash out refinancing provides a one time funding, which replaces an existing mortgage with a new, larger home loan, while a HELOC is a little more like a credit card, allowing you to borrow as needed up to the agreed credit limit.
This structure also has an impact on your current mortgage. Cash out refinancing replaces the existing mortgage, which will change the terms including the repayment schedule and interest rates. Your new mortgage terms will be determined by the current interest rates, your current credit score and your financial profile. On the other hand, HELOCs do not impact the terms of your existing mortgage.
There are also crucial differences in the repayment terms. Cash out refinancing requires that you start to immediately repay the loan with monthly payments to cover the interest and principal balance, similar to your existing mortgage. HELOCs have two phases, during the draw period, you may only need to make interest payments, while in the repayment period, your repayment will include both the interest and principal.
Another key difference relates to interest rates. Traditionally, cash out refinancing has a fixed interest rate that can provide predictable monthly repayments, while typically HELOCs have variable interest rates, which means they are subject to change if the market rates adjust. However, many lenders have flexible packages, so you may be able to access an adjustable rate refinance deal or a fixed rate HELOC to suit your specific needs and preferences.
HELOC vs Cash Out Refinancing: Which One Should You Choose?
As we’ve covered, there are both pros and cons associated with HELOCs and cash out refinancing. This can make choosing between them a little daunting. However, there are some considerations you can access to make your decision.
The Loan Terms
Cash out refinancing means that you will replace your existing mortgage with a new mortgage and new terms. You will need to ensure that these terms are favorable to you. On the other hand, HELOCs do not impact your existing mortgage.
So, you will need to evaluate whether it would be beneficial to replace your existing mortgage or not. If you were able to lock in a low fixed rate with your current mortgage, it may not be beneficial to replace this. However, if mortgage rates were higher when you took out your original loan, it could work out cheaper to replace it now.
Receipt of Funds
With a cash out refinancing deal, you will receive a lump sum after the loan closes. Your new lender will pay off your existing mortgage including any associated costs such as closing costs, homeowners insurance and real estate taxes and then you will receive the remaining funds.
With a HELOC, you will have an agreed line of credit that you can access at any time during the draw period, which is typically ten years. You can opt to make interest only payments on the funds you’ve drawn, so you will only pay for the funds you need.
So, if you know exactly how much you need and require a one time lump sum, a cash out refinancing package will be simpler. However, if you’re planning a renovation or other spending that may require some flexibility, a HELOC will allow you to draw funds and and when needed during the draw period.
The Rates
Borrowing rates are calculated based on your credit score, financial situation and other factors, but you will also need to think about whether you prefer a fixed or variable rate. Fixed rates allow you to know exactly how much your home loan will cost each month, and are more typical with a refinancing deal. Variable rates are more common with HELOCs and these can both increase and decrease over time. This can be beneficial when rates are dropping in the marketplace, but you could find your costs increase significantly if rates rise.
Closing Costs
Since refinancing involves setting up a new mortgage and clearing the existing mortgage, you will incur closing costs. Typically, HELOCs do not involve these upfront costs.
The Tax Implications
There are tax implications associated with refinancing since the IRS views this as debt restructuring. Essentially, it means that the credits and deductions you can claim are likely to be significantly less than when you took out your initial mortgage. However, since the refinancing is considered a loan, you do not need to include the funds as income when you file your taxes.
With either option how you use the funds will determine if they are tax deductible. You can only claim a tax deduction if the funds are used for capital home improvements such as renovations or remodeling.
| Feature | HELOC (Home Equity Line of Credit) | Cash-Out Refinance |
|---|---|---|
| Definition | A revolving credit line using home equity as collateral | A new mortgage for more than you owe, receiving the difference in cash |
| Loan Structure | Works like a credit card; borrow as needed during draw period | Replaces current mortgage with a larger one |
| Interest Rate Type | Variable (often tied to prime rate) | Usually fixed |
| Access to Funds | As needed, up to a credit limit | Lump-sum payment at closing |
| Repayment Terms | Interest-only during draw period, then repayment period | Full principal and interest payments begin immediately |
| Closing Costs | Lower or no closing costs | Typically 2%–5% of the loan amount |
| Best For | Ongoing or uncertain expenses (e.g., home improvements over time) | Large one-time expenses (e.g., debt consolidation, major renovations) |
| Impact on Mortgage | No change to existing mortgage | Replaces your current mortgage |
| Tax Deductibility | Interest may be deductible if funds used for home improvements | Interest may be deductible if used for home improvements |
| Flexibility | High – borrow what you need, when you need it | Lower – funds disbursed all at once |
FAQs
Can You Use Cash Out Refinancing to Repay a HELOC?
Provided that you have sufficient equity to cover the cash out refinancing, yes, you can use the funds to repay a HELOC.
Which is Easier to Qualify For?
Typically, cash out refinancing is easier to qualify for compared to HELOCs, since HELOCs carry a greater risk for the lender. Additionally, cash out refinancing is more readily available, as you may not find HELOCs offered by your preferred bank or financial institution.
Which Offers More Funds?
The amount you can borrow with both a cash out refinance or a HELOC depends on the equity remaining in your home. Typically, lenders won’t lend more than 80% of the home value for refinancing and up to 85% for HELOCs. However, this can vary from lender to lender and you need to consider your existing mortgage to calculate the current equity in your home.
When Do I Need to Repay the Debt?
Cash out refinancing replaces an existing mortgage, so your monthly repayments will start as soon as the loan funds are disbursed. Typically, HELOCs offer interest only repayments on the funds borrowed during the draw period. It then switches to monthly repayments covering both the interest and principal balance during the repayment period.
Which Has a Lower Credit Score Requirement?
Generally, cash out refinancing has a lower credit score requirement. Typically, you’ll need a credit score of at least 620, while you may need a score of 680 or higher to qualify for a HELOC.
Which Has Higher Borrowing Rates?
Cash out refinancing is less risky for a lender, so this is reflected in lower rates. However, you do need to factor in the higher upfront fees, since you will have closing costs associated with the loan. Of course, the specific rates will depend on your credit score and financial profile, along with the loan terms.
Choosing between a HELOC and a cash out refinancing deal can be a complicated decision, but remember that everyone has unique preferences, circumstances and requirements. Therefore, it is important to assess your needs to determine whether refinancing could provide a lower rate on your home loan, even if you need to cover closing costs. You will also need to think about how much you want to borrow. For those who only require a relatively small percentage of equity, a HELOC may be a better option as you can avoid refinancing closing costs. On the other hand, if you need more funds, the slightly lower rates for refinancing could outweigh the closing costs.
Remember that if you’re not sure of exactly how much you need or if the expenses may occur over a longer period, a HELOC does provide greater flexibility. While it may be a little more complex to organize, it could save you money in the long term.
