HELOC Versus Cash-Out Refinance

Cash-Out Refinance

Most homeowners have experienced substantial equity appreciation in their primary residence over the past several years, however that may be easing in the years ahead. The home’s current equity is defined as the difference between the outstanding balance of all mortgages and debts secured by the property, and its real property value.

For instance, if you bought your house for $400,000 and have a mortgage debt of $250,000, you would now have $150,000 in equity in your house, however mortgage lenders, when offering cash-out transaction will only lend up to 80% of the property value, or in this case; $320,000. The net cash you would receive is $320,000 minus $250,000 owing or $70,000, minus any costs to close.

Cash Out transactions act as a new, first mortgage on the property which pays off the current mortgage or mortgages on the property and will re-start a new term for repayment.

The steps of a cash-out refinance are essentially the same as those steps when you obtained the mortgage to purchase the property. You pick a lender, submit your application, get approved and close. The net proceeds, that is; the amount of the loan minus all costs and payoffs, are sent to you immediately (within a day of funding the new loan) and may be used by you for any purpose whatsoever.

Home Equity Line of Credit

Alternatively, homeowners may borrow money from the available equity in their primary residential property with a HELOC (Home Equity Line of Credit), which acts as a second mortgage on the property (meaning it gets paid off only after the 1^st mortgage gets paid in full, the 1^st mortgage has priority, and therefore tends to be better priced).

HELOCs work in a manner which is similar to a credit card, allowing you to access and use funds up to an approved credit limit and term (time period).

HELOCs offer some versatility since interest charges do not accrue until you borrow against your credit line, and acquisition costs for the HELOC will be very low or in most cases cost nothing. The reason the costs are so low is the pricing structure of HELOCs; they have an interest only repayment schedule (lower payments monthly), and they are adjustable-rate instruments with interest rate caps as high as 24%. Worse than most credit cards! HELOC lenders make their money in interest collection!

Since the idle funds have no interest charges, HELOCs may be a popular avenue when looking for an emergency source of funds, especially for a short period of time.

HELOCs act as an additional loan to your residence, meaning another mortgage payment every month and additional debt to cover.

HELOC loans have distinct time periods for borrowing and repayment; the phase of first ten years is considered the draw period where you may access the credit line for funds, the second period is the repayment period, typically a 20-year period where the credit line balance is frozen and a fully amortized repayment schedule (principle & interest) is required to pay off the HELOC over time. This can result in a substantially higher monthly payment, at substantially higher rates as HELOC interest rates adjust monthly. Not a very good idea.

Remember; you will no longer be able to use HELOC funds once your initial draw period of 10 years has passed, and you must begin making full payments every month that include both the interest and principal balance.

In summary, the HELOC may be a useful instrument for short term borrowing, but watch out if you are borrowing large sums from your home equity. You should compare the costs and the fixed rates of interest available from both conventional cash out refinancing on a first mortgage and a HELOC.