Comparing a Cash-Out Refinance With a HELOC for Emergency Funds

1. Cash-out refinancing

A cash-out refinance is a type of mortgage refinancing. Here's how it works: You apply for a new mortgage that's greater than the amount of your existing mortgage principle but less than the current value of your home. You then use the money from the new loan to repay your original mortgage — and pocket the rest of the cash. You continue making monthly mortgage payments on the new loan until it is repaid in full.

Since most cash-out refinancing is done with a fixed-rate mortgage, you make monthly payments at a set interest rate until the amount you borrowed is repaid. While there are different loan terms you can choose from when you refinance, the most common are 15-year and 30-year loans.

2. Home equity line of credit (HELOC)

A HELOC, or home equity line of credit, is a line of credit that's based on the equity in your home. A HELOC is separate from your mortgage. Instead, it's a line of credit where the collateral is the equity in your home.

With a HELOC, you can borrow the amount you want whenever you want, provided that the line of credit is open and you have funds available. During the period of time you can borrow from your HELOC — known as the “draw period" — you must pay at least the interest on whatever your outstanding balance is. At the end of the draw period, you enter the “repayment period," where you must repay any outstanding balance. A common term for a HELOC is 25 years, with the draw period lasting 10 to 15 years, and the repayment period lasting another 10 years.

Which is right for you?

It can be difficult to make financial decisions during an already stressful time, but here are some scenarios that can help illustrate which approach might be a better fit, based on your personal situation.

Consider a cash out refinance if:

• Today's mortgage rates are considerably lower than when you got your mortgage. It's important to look at current rates since they can fluctuate . If the rate you are quoted is better than your current one, refinancing at this lower rate can serve double-duty by allowing you to access the cash you need today, while saving you money on your mortgage in the long run. Consider how much cash you want to withhold in refinancing to best balance access to cash with your new monthly payments. The more cash you withhold, the higher your monthly payment will be.
• You want a fixed interest rate with a set payment schedule. If you refinance to a fixed-rate mortgage, you'll know exactly how much you'll owe each month and won't have to juggle multiple payments, as compared to the variable interest rates of a HELOC.
• You are able to pay the closing costs of the new loan, which typically run 3% to 5%. These closing costs can also be rolled into the new mortgage, but if you don't pay them up front, the lender is likely to charge a higher interest rate.

Consider a HELOC if:

• You want a lot of flexibility. HELOCs work like credit cards. Because a HELOC is a revolving line of credit, you only pay interest on what you borrow, rather than the full amount. In other words, while you have the option to borrow a large sum, you'll pay interest only on what you actually use, rather than the full amount available. Therefore it offers a safety net that you can tap if your personal financial situation worsens, but doesn't lock you into making interest payments on money you don't currently need.
• You need access to your equity fast. The approval and origination process is much easier and faster than with a cash-out refi, so you can access your money sooner. That can be appealing at time when there are a lot of economic unknowns — either in your own personal financial situation or in the national economy.
• You are unemployed. Since the approval requirements are slightly less stringent than for a cash-out refi (where you have to qualify for the new mortgage), you may still be able to qualify for a HELOC if you have a certain amount of home equity.

The times when you need the money the most can also be the times when it's hardest to access. Since both a HELOC and cash-out refinance require you provide your current financial information, considering your options sooner rather than later can be wise.