Key takeaways
- A cash-out refinance and home equity loan are both strategic ways to access the ownership stake you’ve built in your home.
- A cash-out refinance is the process of replacing your existing mortgage with a new one, while a home equity loan is a second mortgage you take out on top of your primary one.
- A home equity loan could work if you have a big ownership stake and need a large, fixed lump sum.
- A cash-out refinance may be the smarter option if you want to reduce your mortgage payment and have just one big debt.
If you need money and have a sizable amount of home equity built up, you may want to tap into that equity for the funds. Both a cash-out refinance and a home equity loan allow you to borrow against your ownership stake, using your home as collateral.
A cash-out refinance is the process of replacing your existing mortgage with a new one, while a home equity loan is a second mortgage you take out on top of your primary one.
If you’re weighing a cash out refinance vs. a home equity loan, here are the benefits and risks to consider with both options.
In this article
- Cash-out refinance vs home equity loan
- How to decide which is right for you
- When does a home equity loan make sense?
- Frequently asked questions
Cash-out refinance vs home equity loan
Cash-out refinance
- Fixed or adjustable interest rate
- Lower interest rates, comparable to mortgage rates
- Must maintain 15%- 20% home equity
- Mortgage interest is tax-deductible (on original principal; cashed-out portion deductible if used on the home)
- Longer application process
Home equity loan
- Fixed interest rate
- Higher interest rates, 2-3% above mortgage rates
- Must maintain 15% – 20% home equity
- Tax-deductible interest, provided funds are used to “buy, build, or substantially improve” the home
- Shorter application process
What is a cash-out refinance?
A cash-out refinance pays off the remaining balance on your first home loan and replaces it with a new mortgage. The newly refinanced loan amount is for the remaining debt owed on the first mortgage, plus the amount you’re “cashing out” — that is, borrowing — from the equity. The loan term is generally up to 30 years, and the interest rate — which can be fixed or variable — will reflect prevailing market rates. Cash-out refi rates tend to be a bit higher than traditional rate-and-term refinance rates.
Some lenders and federal programs may set lower credit score requirements for cash-out refinancing. Because the refinancing lender assumes the first mortgage during a cash-out refi, that lender becomes the primary lien-holder in the event you default. With easier access to your home as collateral, lenders might be willing to offer lower rates compared to what you’ll get with a home equity loan.
Pros
- Lower credit requirements
- One loan rather than multiple loans
- May boost credit score
- Lower interest rates than other types of debt
- Can be used for any purpose
Cons
- Risk of foreclosure
- Long application process
- 20% home equity required
- Closing costs can be high
- Low debt-to-income ratio required
What is a home equity loan?
A home equity loan is often regarded as a way to fund big-ticket purchases, make costly home upgrades and consolidate high-interest debt.
It’s a second mortgage against your home with its own terms and interest rate that are separate from your first mortgage. By refinancing using a home equity loan, you’re borrowing against the home’s equity — the difference between the appraised value of your home and what you owe on your mortgage. You can typically borrow up to 85 percent of your home’s equity. However, your loan amount is also contingent on other financial factors, like your income and credit history, and the size of your first mortgage.
Home equity loan rates may be higher than those of refis. The differences, however, vary significantly from bank to bank and over time. Home equity loans typically have a repayment period of up to 30 years.
Some lenders may not charge origination fees, which results in lower (or no) closing costs. Home equity loans also don’t require mortgage insurance, unlike some cash-out refinances.
Pros
- Fixed rates offer certainty
- Lower rates than unsecured debt
- Long repayment terms/low monthly payments
- Interest can be tax-deductible
- Use the cash for almost any purpose
- Foreclosure risk: home is collateral
- Higher credit requirements
- 15%-20% home equity required
- Must be paid off when home is sold
- Easy to overborrow due to lump sum distribution
How to decide which is right for you
When does a cash-out refinance make sense?
Cash-out refis generally have lower interest rates and are easier to qualify for, making them appealing for people who have less-than-perfect credit scores. They offer an option for homebuyers to borrow a lump sum for planned expenses, with only a single repayment to track.
However, they replace your existing mortgage with a new one, meaning a new payment term and interest rate. You’ll have to pay new closing costs, too. If you got a great deal on your initial mortgage, you might not want to give it up if rates have substantially risen lately. Or, if you’ve had your mortgage a long time, and your payments are now primarily going towards principal (not interest), you might not want to reset the amortization clock with a new loan.
A cash-out refi also tends to make sense if you were thinking of swapping out your current mortgage anyway — perhaps because of a big drop in interest rates. Also if you can get a better rate on a new mortgage than you have on your existing one or, you want to adjust the repayment term of your loan.
When does a home equity loan make sense?
Home equity loans let you keep your existing mortgage and add a new loan on top. That can be helpful if you got a good deal on your original mortgage and want to keep it for as long as possible. Or just don’t want to mess with it, in general.
A home equity loan is an option for those who’ve built up a lot of equity in their homes, and who have a strong credit history and score. The overall process of taking out a home equity loan can be simpler and quicker than a cash-out refinance, too. Closing costs do exist, but they tend to be lower than those for a refi.
| Refi with 15-year cash-out refi | Refi with 15-year home equity loan | |
|---|---|---|
| Loan amount | $150,000 | $150,000 |
| Closing costs | $2,400 | $600 |
| Interest rate | 5.5% | 7.25% |
| Monthly principal and interest | $1,225 | $1,369 |
| Total cost in first 24 months | $31,800 | $33,456 |
| Total cost in first 48 months | $6,200 | $66,312 |
| Total cost in first 60 months | $75,900 | $82,740 |
The above scenario illustrates the potential benefits of a cash-out refinance over a home equity loan. Cash-out refinancing tends to come with a lower interest rate than home equity loans. While home equity loans have lower closing costs, they are typically more expensive over time due to their higher interest rates.
If you have good to excellent credit and are able to find a home equity loan with a low interest rate or a lender that waives closing costs, a home equity loan could be the right choice. However, the lower interest rates associated with cash-out refinance is a major advantage.
Bottom line on cash-out refi vs. home equity loan
If the cash-out refinancing vs. home equity loan contest, remember that both are strategic ways to access the equity you’ve built in your home. However, you have to consider your financial situation, goals and how you plan to use the funds to determine the best approach. It’s equally important to consider the qualification criteria for both options to gauge which you’re most likely to get approved for.
A home equity loan could work if you have a strong credit score and wish to pull out a large, fixed lump sum. Still, a cash-out refinance may be the smarter option if you want to reduce your mortgage payment and pull funds from your equity using a single loan product.
Always shop around and compare offers from multiple lenders regardless of which path you choose. Also, request an itemized list of lending fees from the lender you choose so you can calculate how much the loan will cost.
Frequently asked questions
There is no limit on how many times you can refinance your home, but you typically have to wait at least six months between cash-out refinances. This is called a “seasoning” period. Different lenders have different requirements.
A cash-out refinance is considered a loan, not income, so you will not have to pay taxes on the money you receive. Your cash-out refinance may be eligible for a tax deduction if you use the money to make permanent improvements to the home. This could include projects like putting in a swimming pool, adding a bathroom or upgrading the heating and air conditioning system.
A no-cash-out refinance is the process of refinancing your home for less than or the same amount that you owe on your mortgage, plus closing costs on the new mortgage. This type of refinancing allows you to transfer to a loan with better terms and a lower interest rate, but you do not get any additional funds.
Getting a home equity loan can take anywhere from one week to two months, but most lenders advertise an average window of two to six weeks.
A home equity loan can be used for virtually anything you want, but it is most commonly used to consolidate debt or finance remodels or renovations. Because these loans tap into your home’s equity, it is smart to use the funds for home improvement, increasing the value of your home. However, it is important to use the funds wisely and make sure you don’t take out more than you need. If you can’t pay back the loan, you may lose your home.
One other option that relies on your home equity is a home equity line of credit (HELOC). HELOCs give you more flexible access to your equity, letting you draw funds multiple times whenever you need to. However, they usually have variable interest rates, which means your payments can be unpredictable.You can also consider unsecured loans, like personal loans. These have faster application and approval processes but lower limits and higher interest rates.
Additional reporting by Mia Taylor
I'm an experienced financial expert with a deep understanding of mortgage-related concepts and strategies. My expertise comes from years of working in the financial industry, where I've helped individuals navigate complex decisions regarding their homes and mortgages. I've stayed abreast of industry trends, lender practices, and regulatory changes, ensuring that my knowledge is up-to-date and comprehensive.
Now, let's delve into the key concepts discussed in the article on cash-out refinance vs. home equity loan:
1. Cash-Out Refinance:
- Definition: A cash-out refinance involves replacing an existing mortgage with a new one, paying off the remaining balance on the original loan, and borrowing additional funds from the home's equity.
- Loan Terms: The new mortgage can have a term of up to 30 years, and the interest rate may be fixed or variable.
- Interest Rates: Cash-out refinance rates are typically slightly higher than traditional rate-and-term refinance rates.
- Credit Requirements: Some lenders and programs may have lower credit score requirements for cash-out refinancing.
- Benefits: Lower interest rates, potential credit score boost, and the ability to use funds for various purposes.
- Risks: Risk of foreclosure, a lengthy application process, and the need to maintain 15%-20% home equity.
2. Home Equity Loan:
- Definition: A home equity loan is a second mortgage taken out on top of the primary mortgage, allowing borrowers to access a lump sum of money using their home's equity as collateral.
- Loan Terms: Home equity loans typically have repayment periods of up to 30 years.
- Interest Rates: Rates may be higher than those of refinance loans, but the differences vary among lenders.
- Credit Requirements: Higher credit requirements, and borrowers must maintain 15%-20% home equity.
- Benefits: Fixed interest rates, lower rates than unsecured debt, and interest may be tax-deductible.
- Risks: Foreclosure risk, the temptation to overborrow due to lump-sum distribution, and closing costs (though they may be lower than those for a refinance).
3. Choosing Between Cash-Out Refinance and Home Equity Loan:
- Factors to Consider: The decision depends on financial goals, current mortgage terms, credit score, and the purpose of accessing funds.
- Cash-Out Refinance Advantages: Lower interest rates, potential credit score boost, and a single loan for planned expenses.
- Home Equity Loan Advantages: Keeps the existing mortgage, simpler and quicker application process, and potentially lower closing costs.
4. Scenario Comparison: Cash-Out Refinance vs. Home Equity Loan:
- Example Scenario: Comparing a 15-year cash-out refinance with a 15-year home equity loan, illustrating potential cost savings with the cash-out refinance despite higher closing costs.
5. Frequently Asked Questions:
- Refinancing Frequency: No strict limit on how many times you can refinance, but there's usually a waiting period between cash-out refinances.
- Tax Implications: Cash-out refinance is considered a loan, not income, and may be tax-deductible if used for home improvements.
- No-Cash-Out Refinance: Refinancing without receiving additional funds, focusing on better loan terms and lower interest rates.
- Home Equity Loan Processing Time: Can take from one week to two months, depending on the lender.
- HELOC as an Alternative: Mention of a home equity line of credit (HELOC) as another option with more flexible access to equity.
6. Additional Options:
- Unsecured Loans: Consideration of alternatives like personal loans with faster processes, though they come with lower limits and higher interest rates.
In conclusion, both cash-out refinance and home equity loans offer strategic ways to access home equity, but the choice depends on individual financial situations and goals. It's crucial to consider qualification criteria, compare offers from multiple lenders, and assess the overall costs of each option. Always approach such decisions with a clear understanding of your unique circ*mstances.
