Sure, your home’s main purpose is to give you and your family a place to live, but it’s also your own personal real estate investment. Home equity is a valuable way to use homeownership to your advantage. By borrowing against your home’s equity, you can get funds for debt consolidation, home improvement or anything else you choose.
The two most common ways to tap into home equity are cash-out refinances and home equity loans. But what’s the difference? We’ll break down and compare these two options to help you find the loan that makes the most sense for you.
Cash-Out Refinance vs. Home Equity Loan: Similarities and Differences
Cash-out refinances and home equity loans both offer ways to unlock the equity within your home. They provide fast access to funds and have similar borrower requirements, but one may have certain advantages based on the specific situation of the borrower. We’ll go over some important similarities and differences between the two options.
|Cash-Out Refinance vs. Home Equity Loan|
|Quick access to your money, which can be used however you want|
|Generally require an appraisal|
|Similar credit requirements, usually a credit score of 620+|
|Uses the home as collateral, missed payments could lead to foreclosure|
|Cash-Out Refinance||Home Equity Loan|
|Pays off your existing loan and issues a new home loan in its place||Is a separate loan entirely, leaves your first mortgage intact|
|Offers more profit and less risk to the lender (if a full refinance), so lower rates for you||Is a faster and easier loan, so you’ll pay a higher interest rate|
|Can borrow up to 80% of the home’s value on most loans (VA loans allow 100% cash-out)||Can borrow up to 85% of the home’s value|
|Closing costs and fees associated with the refinance||Closing costs and fees associated with the home equity loan|
|Term options of 8 – 30 years||Shorter repayment period of 5 – 15 years|
What Is a Cash-Out Refinance?
A cash-out refinance is a new home loan that replaces your existing mortgage, allowing you to borrow up to 80% of your home’s value with most loan options. The difference between what you borrow and the amount of the loan you’re refinancing is given to you in cash, thus the name “cash-out refinance.”
The process is much like any other refinance, with the potential for an appraisal and key requirements, such as a max 80% loan-to-value (LTV) ratio and a 620+ credit score for conventional loans.
Veterans Affairs (VA) loans or Federal Housing Administration (FHA) loans have different qualifications and max LTVs, and there are restrictions around refinancing too soon after getting your mortgage.
With any home equity loan or cash-out refinance, most lenders won’t let borrowers take out the full equity value of their home. But you can still get a sizable sum of money if you’ve built up enough equity.
Consider this scenario for finding the amount of money you could get with a cash-out refinance:
Your property is currently valued at $300,000, and your remaining mortgage balance is $150,000.
- Step 1: Multiply your property’s value by 80% to find the maximum amount available to borrow. For this example, the calculation looks like: ($300,000 x 80%) = $240,000.
- Step 2: Subtract the remaining mortgage balance to find the cash available to access. This would be: $240,000 – $150,000 = $90,000.
If you did a cash-out mortgage refinance with this equation, you could get $90,000 in cash. Your new mortgage would be the unpaid mortgage loan amount plus the equity paid out, or $240,000.
Depending on the mortgage lender, a typical cash-out refinance loan has a 30-year loan term and could carry a different interest rate than your current home loan. The new interest rate is applied to the new mortgage balance.
Because you’ll eventually repay the amount you’ve cashed out, it doesn’t count as income and isn’t subject to taxes.
A cash-out refinance is best for someone who wants to tap into their equity and can benefit from capturing a lower interest rate than other loan options.
Pros and cons of a cash-out refinance
From a lump sum of cash to simplified finances, a cash-out refinance offers plenty of perks.
A cash-out refinance allows you to receive a check with a one-time lump sum of money, which can be used to consolidate debt, make home improvements or whatever else you wish.
A cash-out refinance will usually have a lower interest rate than a home equity loan because it’s the primary loan rather than secondary.
A cash-out refinance will usually have a longer repayment term than a home equity loan. Just like a traditional refinance, a cash-out refinance offers terms ranging from 8 – 30 years.
With a cash-out refinance, you only have to make one payment each month. This can be helpful if you’re trying to simplify your finances.
A cash-out refinance will have closing costs and fees, which can vary by lender.
As with any loan where your home is used as collateral, you risk foreclosure if you’re unable to make payments.
To qualify for a cash-out refinance, you’ll need to have at least 20% equity in your home.
What Is a Home Equity Loan?
A home equity loan allows you to access the equity in your home without paying off your existing mortgage in a complete refinance. Like with a cash-out refinance, you can use this money for whatever you want, such as fixing your house or buying a new car.
To get a home equity loan, you need to have some equity in your house – but not quite as much as you’d need for a cash-out refinance. A home equity loan requires at least 15% equity in your home, or a LTV ratio of 85% or less.
Though each lender is subject to their own underwriting guidelines, lenders usually expect you to have:
- At least 15% (20% preferred) equity in your home
- A maximum combined loan-to-value (LTV) ratio of 85%
- A debt-to-income (DTI) ratio of 36% or lower
Very similar to a home equity loan is a home equity line of credit, often called a HELOC. HELOCs and home equity loans differ in that the HELOC provides access to your equity in the form of a line of credit.
As you make payments, you regain access to that line of credit, up to the limit. A home equity loan, on the other hand, is a lump sum you get all at once and then make payments over time.
A home equity loan is best for people who need a set amount of money and can make fixed payments over time.
Pros and cons of home equity loans
Home equity loans are a fast way to access cash without the hurdles of a full refinance.
The interest rate on a home equity loan is usually fixed, making it easy to budget for your monthly payments.
A home equity loan is slightly less expensive to obtain than a cash-out refinance.
Home equity loans are secured by your home, so lenders will offer lower rates than unsecured loans or credit cards.
A home equity loan doesn’t pay off your primary mortgage. You’ll have one payment for your primary mortgage and a separate payment for your home equity loan.
Your home equity loan is secured by your home. So if you can’t make payments, you could lose your home.
If your credit is below a 680 or your DTI ratio is over 36%, it can be difficult to get approved for a home equity loan.
Example of Cash-Out Refinance vs. Home Equity Loan on a 15-year Loan
To determine which of these two options comes out on top, we have to do a little math!
In this case, we’re going to compare a 30-year cash-out refinance versus home equity loan on a 15-year term. We have a $500,000 home and a current mortgage of $200,000 – the goal is to access as much cash as possible for a home renovation project.
Home Equity Loan
|Cash-Out Refinance||Home Equity Loan|
|Max Loan Amount||$400,000 (80% LTV)||$425,000 (85% LTV)|
|Repayment Term||30 years||15 years|
|Total Lifetime Cost||$655,089 (includes original $200,000 mortgage)||$398,820 (doesn’t include original $200,000 mortgage)|
You can determine which loan will be best for you by using a mortgage cost calculator and considering your personal circumstances and goals.
You’ll only lose equity to the extent that your refinance exceeds your original loan amount. Any cash that’s taken out during the refinance is coming from the equity in your home.
The cash you receive from a cash-out refinance is not taxed as income because you’ll be repaying the loan. However, you may be able to deduct the interest paid on your loan if you itemize your taxes.
You’ll usually need an appraisal for a cash-out refinance and a home equity loan because the lender will need to know how much your home is worth to determine how much equity you have.
Which Loan Option Is Right for Me?
Deciding whether a cash-out refinance or home equity loan makes sense for your situation is a personal financial decision. Consider factors that may affect your loan, such as how much equity you have, how you plan to use your funds and your overall financial goals.
Fannie Mae. “Eligibility Matrix.” Retrieved November 2022 from https://singlefamily.fanniemae.com/media/20786/display