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What is the difference between a cash-out refinance and a home equity line of credit (HELOC)?

Frequently asked questions? Gurjant singh Gurjant singh 22 Sep

Cash-Out Refinance vs. Home Equity Line of Credit (HELOC): Which is Right for You?

As a homeowner in Ontario, you might find yourself in a situation where you want to tap into the equity you’ve built up in your home. Whether you’re planning a renovation, consolidating debt, or funding a major expense, two popular options to access your home’s equity are cash-out refinancing and a Home Equity Line of Credit (HELOC).

But how do these two options differ, and which one is the better choice for your financial needs? Let’s break it down.

1. What is a Cash-Out Refinance?

A cash-out refinance allows you to replace your existing mortgage with a new, larger mortgage, and you receive the difference in cash. This option essentially lets you borrow more than what you currently owe on your home and pocket the excess funds. The new loan pays off your old mortgage, and you’ll start making payments on the new, larger amount.

How It Works:

  • You take out a new mortgage for more than what you owe on your current one.
  • The difference between the new mortgage amount and your current balance is given to you in cash.
  • The new loan typically comes with a fixed or variable interest rate, depending on your preference.

Example:

  • Current mortgage balance: $300,000
  • Home’s current value: $500,000
  • New mortgage (after refinance): $400,000
  • Cash you receive: $100,000

Pros of Cash-Out Refinancing:

  • Lower Interest Rates: The interest rates for cash-out refinancing are typically lower than for HELOCs since you’re refinancing your entire mortgage.
  • Single Monthly Payment: You’ll have one fixed payment covering both your mortgage and the cash-out.
  • Potential for Long-Term Savings: If you refinance into a lower interest rate, you could save money over the life of your mortgage.

Cons of Cash-Out Refinancing:

  • Closing Costs: You’ll incur closing costs, similar to when you first purchased your home.
  • Higher Monthly Payments: Since you’re increasing your loan amount, your monthly payments may rise.
  • Extended Loan Term: If you reset your loan to a longer term, it may take more time to fully pay off your home.

2. What is a Home Equity Line of Credit (HELOC)?

A HELOC is a revolving line of credit that is secured by the equity in your home. Unlike a cash-out refinance, a HELOC allows you to borrow as much or as little as you need, up to a certain limit, over a set period (often 10 years). It works much like a credit card — you only pay interest on the amount you borrow.

How It Works:

  • You receive a credit limit based on a percentage of your home’s equity.
  • You can draw from the line of credit as needed during the “draw period.”
  • Once the draw period ends, you enter the repayment phase, where you start paying back both the principal and interest.

Example:

  • Home’s value: $500,000
  • Mortgage balance: $300,000
  • Maximum HELOC limit (80% of home’s value): $400,000
  • Available HELOC: $100,000

Pros of a HELOC:

  • Flexibility: You can borrow only what you need and when you need it.
  • Interest-Only Payments (During Draw Period): You only need to make interest payments during the draw period, reducing monthly expenses.
  • Lower Upfront Costs: There are usually lower initial fees compared to refinancing, and no closing costs in many cases.

Cons of a HELOC:

  • Variable Interest Rates: HELOCs typically come with variable interest rates, which means your payments can fluctuate if rates rise.
  • Risk of Overborrowing: Because HELOCs are revolving, there’s a temptation to borrow more than you need, potentially leading to financial strain.
  • Repayment Terms: Once the draw period ends, you must repay both the principal and interest, which can lead to significantly higher payments.

Key Differences Between Cash-Out Refinance and HELOC

Feature Cash-Out Refinance HELOC
Type of Loan Replaces your current mortgage Revolving line of credit
Funds Disbursement Lump sum payment Borrow as needed, pay interest only on what’s borrowed
Interest Rates Fixed or variable rates, usually lower Variable rates, potentially higher
Repayment Monthly mortgage payments Flexible payments during draw period, principal + interest after
Closing Costs Yes, similar to a mortgage Lower or no closing costs
Risk of Higher Payments Yes, due to larger loan amount Yes, due to variable interest rates and repayment phase

Which Option is Right for You?

When to Choose Cash-Out Refinance:

  • You want to take advantage of lower interest rates and lock in a fixed rate.
  • You need a large sum of money upfront for a specific purpose (e.g., home renovations, debt consolidation).
  • You prefer having a single monthly payment for both your mortgage and the equity you’re accessing.

When to Choose a HELOC:

  • You want flexibility in how and when you borrow.
  • You’re comfortable with variable interest rates and understand that payments can fluctuate.
  • You may need access to funds over time for ongoing projects or expenses.

 

Can You Pay Principal During the HELOC Draw Period?

Yes, most Home Equity Lines of Credit (HELOCs) allow you to make principal payments during the draw period in addition to the required interest payments. Although HELOCs typically only require interest payments during the draw period, paying down the principal can be a smart strategy for reducing overall debt faster and lowering future interest costs.

 

Benefits of Paying Principal Early

1. Lower Interest Costs:

Since interest on a HELOC is calculated based on your outstanding balance, paying down the principal will reduce the amount of interest charged. The faster you reduce your principal, the less interest you’ll accumulate over time.

2. Reduce Debt Faster:

By making payments toward both the principal and interest during the draw period, you can reduce your total debt faster and potentially eliminate the HELOC balance entirely before the draw period ends.

3. Avoid a Payment Shock:

Paying down the principal during the draw period can help you avoid the higher payments that would otherwise be required when the repayment phase begins. This helps prevent a sudden increase in monthly payments once both principal and interest become due.

 

Published by: Gurmaan Mortgages

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