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Home Equity Loan vs. Cash-Out Refinance

TLDR

What You Need To Know

  • Cash-out refinances replace your current mortgage with a new one, while home equity loans or HELOCs are second loans or mortgages
  • You can borrow against your home’s equity to get funds to use however you want, like for debt consolidation, home improvement or an expensive emergency
  • Most lenders won’t let borrowers take out the full equity value of their home, but you can still get sizable sums of money if you’ve built up your equity enough

Contents

Sure, your home’s main purpose is to give you and your family a place to live. And you might even use your home as a kind of real estate investment. 

But if that’s all you think your home is good for, you’re missing out on some other ways to use your homeownership to your advantage, namely by using your home’s equity. You can borrow against your home’s equity to get funds to use however you want, such as for debt consolidation or home improvement, or even to pay for an expensive emergency. 

The two most common ways to tap into your 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.

What Is a Cash-Out Refinance?

A cash-out refinance loan is a new mortgage that replaces your current mortgage. The cash-out refinance loan pays off your old mortgage and gives you some of your home equity as cash. The new mortgage loan will be a higher loan amount than your old loan.

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 sizable sums of money if you’ve built up enough equity. Most lenders will allow borrowers to take out 80% – 85% of their home’s current market value minus the amount still owed on the loan.[1]

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: $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 higher interest rate than your current home loan. The new interest rate is applied to the new mortgage balance, which is the remaining debt owed on the original loan plus the amount you’ve cashed out.

Because you’ll eventually pay back the amount you’ve cashed out, the cash-out amount doesn’t count as income and isn’t subject to taxes.[2]

What Is a Home Equity Loan?

Home equity loans are another way of cashing in on your home’s equity. With home equity loans, you get a second lump-sum loan, commonly referred to as a second mortgage.

Lenders usually expect you to have:[1]

  • at least 15% (20% preferred) equity in your home
  • a minimum combined loan-to-value (LTV) ratio of 80%

You should also know that lenders often prefer that borrowers have a debt-to-income (DTI) ratio of 36% or lower.

What about a home equity line of credit (HELOC)?

Home equity loans aren’t the only way you can leverage your home’s equity to get extra money. Instead of getting a lump sum loan with a home equity loan, you can get a home equity line of credit (HELOC) that functions as revolving credit. This means you only pay interest on money that you’ve used. If you keep a balance, you’ll probably pay an adjustable interest rate.

Cash-Out Refinance vs. Home Equity Loan: What Are the Differences and Similarities?

Both cash-out refinances and home equity loans can be great solutions, but their advantages largely depend on the specific situation of the borrower. We’ll go over some important differences and similarities between the two options.

Differences between a cash-out refinance and home equity loan

The main difference between a cash-out refinance or home equity loan (whether as a home equity loan or HELOC) is the overall structure. Cash-out refinances replace your current mortgage with a new one, while home equity loans and HELOCs are second loans or mortgages.

Doing a cash-out mortgage refinance absorbs your remaining balance plus the equity you want to borrow in cash.

 Home equity loans and HELOCs are new loans in addition to your current mortgage.

Closing costs for a cash-out refinance tend to be a little more than for home equity loans or lines of credit. However, the interest rates for a cash-out refinance are typically lower. 

Similarities between a cash-out refinance and home equity loans

Both options allow you to get access to your money fairly quickly, and you can use the funds however you want as long as you meet the lender’s eligibility requirements. 

With both, you’re using your home’s value as collateral. Missing too many payments could lead to the big and scary F word: foreclosure.

For either cash-out refinancing or home equity loans, you’ll need a credit score of at least 620, depending on the lender.[1]

What Are the Pros and Cons of a Cash-Out Refinance?

Cash-out refinances offer several benefits but also have drawbacks. Let’s dig into the specifics.

Pros of cash-out refinancing

  • Get cash in hand: The major benefit is that you get the total cash-out in hand at once. A standard refinance would reduce your monthly payments rather than hand you cash.
  • Lower interest rates: A cash-out refinance will come with lower interest rates than you’d find with a home equity loan, and lands you on a fixed rate with predictable monthly payments.
  • Pay for debt, home improvement and more: You’re able to use this cash however you want, whether it’s for home improvement or consolidating your debt. For example, you could bundle your higher-interest loans and credit cards together and pay them off with your cash-out, effectively absorbing them into your mortgage.
  • Tax deductions: If you’re using the funds for home improvement, your interest might qualify for tax deductions. According to the IRS, a mortgage secured by a qualified home can be treated as home acquisition debt if it’s used for substantial home improvements such as a swimming pool, an additional bedroom or installing energy-efficient windows.[3]

Cons of cash-out refinancing

  • Fees and costs: A cash-out refinance can come with high closing costs.
  • Risk of foreclosure: Your home is used as collateral on the loan. If you fall behind on payments, you risk foreclosure on your home.
  • Complexity: Cash-out refinances tend to have higher underwriting standards. They also generally come with more complex terms than other kinds of loans.
  • Equity requirement: Your home equity should be at least 20% to be eligible for cash-out refinancing.

What Are the Pros and Cons of Home Equity Loans and HELOCs?

Home equity loans come with their own set of pros and cons.

Pros of home equity loans

  • Fixed interest rate: With a fixed mortgage rate, you’ll have stable and predictable payments over the life of your loan. (Exception: Home equity loans differ from most HELOCs because, as lines of credit, HELOCs carry adjustable rates pegged to the prime interest rate.)
  • Lower fees: You won’t have to pay as much in closing costs. Just know that interest rates are typically a little higher than cash-out finance rates, but still better than personal loans or lines of credit.
  • Flexible use: You can use your lump sum loan for almost anything, such as buying an investment property, paying for education or covering emergency expenses.
  • Tax-deductible: If you use the funds to make home improvements, your interest payments might be tax deductible.

Cons of home equity loans

  • Two mortgage payments: You’ll still have to pay your home equity loan back in addition to your primary mortgage loan. This extra payment can reduce your disposable income and pinch your budget, limiting your ability to save money.
  • Foreclosure: You risk foreclosure if you don’t make payments. That’s because, as with cash-out refinances, your home is used as collateral on the loan.
  • Getting approved: Lenders generally consider second mortgages higher risk because borrowers are more likely to default. If you want to take the max amount of equity out on your home, you’ll need to show lenders you’re reliable and creditworthy with good credit and low DTI.
  • Substantial equity: You’ll need to build a decent amount of equity in your home before you consider taking out a loan – at least 20% in most cases.

How Do I Decide Which Loan Option Is Right for Me?

In the end, deciding whether a cash-out refinance versus home equity loan makes sense for your situation is up to you. 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 situation.

When home equity loans and lines of credit make the most sense

A home equity loan might be your best option if you need a significant amount of cash and have a good credit score and DTI. For example, you could use a home equity loan to purchase a second property or make major home improvements.

Choosing a home equity loan might come down to the interest rate. If refinancing your home to get access to cash or reduce your monthly payment would result in a higher overall interest rate, opting for a home equity loan with a lower rate might be a better option.

HELOCs are a great option for ongoing but smaller home improvements. Because they function as revolving credit, you’ll only ever pay interest on the amount owed. This lets you slowly work on home improvement projects or even have backup funds available in case of emergency.

When cash-out refinancing makes the most sense

If the current market’s interest rates are in your favor, cash-out refinancing might be a superior choice. By getting a new mortgage with a lower rate, you can access cash at a lower overall interest rate on your unpaid balance and cashed-out equity.

This is especially advantageous if you’ve built up a lot of equity in your home, or if your property value has increased significantly.

You’ll also be responsible for just one loan. Even if payments are higher than they would be with a second mortgage or a home equity loan, you simplify your monthly mortgage obligation with one payment instead of two. 

Let Your Home’s Equity Pick Up the Tab

Every homeowner has unique personal finance goals, but sometimes it’s hard to see how their home’s equity can help. Regardless of how you choose to employ your home’s equity, keep in mind that you’ll get the best rates and equity cash-out values if you have a great credit score and low debt. So be extra vigilant about how you manage your money and credit.

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  1. Fannie Mae. “Eligibility Matrix.” Retrieved March 2022 from https://singlefamily.fanniemae.com/media/20786/display

  2. Experian. “Do I Have to Pay Taxes on a Cash-Out Refinance?” Retrieved March 2022 from https://www.experian.com/blogs/ask-experian/is-cash-out-refinance-taxable-income/

  3. Internal Revenue Service. “Publication 936 (2021), Home Mortgage Interest Deduction.” Retrieved March 2022 from https://www.irs.gov/publications/p936#en_US_2021_publink1000229996

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In Case You Missed It

  1. Your home is used as collateral for cash-out refinances or home equity loans, meaning you risk foreclosure if you get behind on payments

  2. Cash-out refinancing may come with higher closing costs, but you’ll probably get lower interest rates

  3. A home equity loan can have a lower interest rate than a credit card or personal loan, making it a great option for debt consolidation

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