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If you have a substantial amount of equity in your home, you may consider tapping into it to fund your goals, such as completing a remodel or going back to school. A cash-out refinance and home equity loan are two options to get money out of the equity in your home so you can put it toward your goals.
But what's the difference between a cash-out refinance and a home equity loan, and how do you know which option is best for you? Here are some of the differences between these two home equity lending options:
| Cash-Out Refinance vs. Home Equity Loan | ||
|---|---|---|
| Cash-Out Refinance | Home Equity Loan | |
| Does it replace your current mortgage? | Yes | No |
| Interest rates | Fixed or variable | Often fixed |
| Repayment terms | 15 to 30 years | Five to 30 years |
| Closing costs | Yes | Lenders may cover the costs |
| Tax deductible | If you use the money to improve the home | If you use the money to improve the home |
| Application process | More intensive application process, which includes a closing period. | Less intensive process |
What Is a Cash-Out Refinance?
A cash-out refinance is a mortgage loan that allows you to replace your current mortgage with a new, larger one and receive the difference in cash. Ideally, your new mortgage has a lower interest rate and monthly payments. You could opt for a shorter term to pay off your home sooner, or a longer one to lower your payments (although you'll generally pay more interest over time).
The process of applying for a cash-out refinance is similar to when you initially took out your current mortgage. Your lender will consider your creditworthiness, debt-to-income ratio (DTI), equity, employment and other factors to determine if you qualify for a cash-out refinance. You'll repay the amount you borrow with a fixed or variable interest rate over a 15- or 30-year term.
Generally, lenders allow you to borrow up to 80% of your home's value in a cash-out refinance. For example, if your home is appraised at $400,000, 80% comes to $320,000. If your current mortgage balance is $260,000, you may be able to get a cash-out refi for $320,000 and receive the $60,000 difference in cash.
You can deduct interest associated with a cash-out refinance as long as you use the funds for capital home improvements that increase your home's value, up to $750,000 in principal mortgage debt.
| Cash-Out Refinance Pros and Cons | |
|---|---|
| Pros | Cons |
| Receive a portion of the property's value as cash | Closing costs of 2% to 6% of loan amount |
| Lower interest rates than other credit options, often including home equity loans | Larger loan amount could raise your monthly payments, even if you secure a lower interest rate |
| New mortgage and cash-out amount are repaid as one loan | Using a loan to consolidate debt could leave you in a worse position if you rack up new balances on credit cards |
| Mortgage interest may be tax deductible | Risk of foreclosure if you're unable to make payments |
What Is a Home Equity Loan?
Unlike a cash-out refinance, a home equity loan doesn't replace your current mortgage. A home equity loan is a second mortgage you'll repay with another monthly payment.
With a home equity loan, you receive funds as a single lump-sum payment, which you must repay over a fixed term ranging from five to 30 years. These installment loans usually come with fixed interest rates, so your payment will remain the same throughout your term. As with a cash-out refinance, you can use the cash for nearly any purpose.
You may be able to deduct the mortgage interest if you use the funds to buy, build or substantially improve your home. However, those savings could be offset by closing costs between 2% and 5% of the loan amount, although some lenders don't charge closing costs.
Home equity loans allow you to borrow up to 80% to 90% of your home's value based on the combined loan-to-value ratio (CLTV), which takes the balance of your first mortgage and the home equity loan into account.
Using the example above, let's say your home is worth $400,000. Depending on the lender and your credit, you may qualify to borrow up to 90% of that value, or $360,000, with good credit. If your current mortgage balance is $300,000, you may qualify for a home equity loan of $60,000.
Getting a home equity loan may be quicker if the lender doesn't require an in-person appraisal. Additionally, some lenders cover the closing costs on the loan.
While these loans often have fixed rates and shorter terms than primary mortgages, remember you'll be making monthly payments on both your home equity loan and original mortgage. If you fall behind on either loan, the lender may be able to foreclose on your home.
| Home Equity Loan Pros and Cons | |
|---|---|
| Pros | Cons |
| Lower interest rates than other forms of credit since the loan is secured by the home | Two mortgage payments could make it difficult to keep up on other bills |
| Fixed interest rates could save money over repayment term | Risk of foreclosure if you miss payments |
| Mortgage interest may be tax deductible | Closing costs, including origination fee, on your home equity loan can range from 2% to 5% of the loan amount |
Cash-Out Refinance vs. Home Equity Loan
Here's a breakdown of how much you might expect to pay on a $100,000 refinance over 10 years at average interest rates versus a similar home equity loan.
| Cash-Out Refinance | Home Equity Loan | |
|---|---|---|
| Loan amount | $100,000 | $100,000 |
| Closing costs | $2,000 to $6,000 | $2,000 to $5,000 or potentially $0 |
| APR | 5.35% | 7.27% |
| Monthly payment | $1,077.85 | $1,175.05 |
| Cost after 1 year | $12,934 | $14,101 |
| Cost after 5 years | $58,096 | $70,503 |
| Total cost after 10 years | $129,341.43 | $141,005.76 |
| Total interest paid | $29,341.43 | $41,005,76 |
In this example, the cash-out refinance saves more in interest costs. One reason cash-out refinances often have lower interest rates than home equity loans is because they assume the primary lien position, while home equity loans are second mortgages. In other words, if you fall behind on payments on a home equity loan, the home equity lender will only get paid after the primary mortgage holder is paid in full.
However, the higher interest rate on a home equity loan may be somewhat offset if you're charged low or no closing costs. Always read the fine print on your loan to understand your potential costs. For instance, some lenders will cover the closing costs but then require you to repay some of the money if you pay off your home equity loan early.
When to Use a Cash-Out Refinance
Deciding whether to use a cash-out refinance depends on your unique financial situation. This option may make sense in certain scenarios, such as when:
- The interest rate on a refinance loan is lower than your existing mortgage, and you need extra funds.
- You want to accelerate the time to pay off your home with a shorter repayment term.
- You want extra cash at a lower interest rate to cover unexpected medical bills, pay educational expenses or consolidate high-interest debt.
- You want a tax break on mortgage interest if you plan on using the funds to renovate your home.
When to Use a Home Equity Loan
A home equity loan is a popular option for borrowers looking to access cash at a fixed rate. You might consider utilizing a home equity loan in the following situations:
- When you want extra funds to reach a financial goal but don't want to refinance your existing mortgage, especially if your current mortgage rate is lower than existing refinance rates.
- When you want to consolidate multiple high-interest debt accounts into a single, lower-interest payment.
- When you're facing a large unexpected expense or short-term financial need and don't want to pay the higher closing costs of a refinance loan—some home equity lenders may even waive closing costs.
- When you plan to use the funds to buy, build or substantially improve your home and wish to deduct the mortgage interest.
Frequently Asked Questions
Before you choose a cash-out refinance or home equity loan, consider these alternatives:
- Home equity line of credit (HELOC): A HELOC is similar to a home equity loan in that it is a second mortgage that allows you to access a portion of your home's equity as cash. However, a HELOC is a revolving line of credit that works like a credit card: You can borrow as much as needed, when you need it, up to your credit limit. Like a home equity loan, a HELOC is secured by your home, which means you could lose it if you fall behind on payments.
- Personal loan: If you don't want to put your home at risk, consider a personal loan instead. Although the interest rates are higher, they're typically much lower than credit card rates, and the application process is relatively straightforward and fast.
- 0% Intro APR credit card: If you want to consolidate high-interest debt, a 0% introductory APR balance transfer credit card gives you up to 21 months to repay your balance interest-free before the promotional rate reverts to the card issuer's standard rate.
Yes, it's possible to refinance your home equity loan in one of two ways, provided you have adequate home equity. You can replace your existing home equity loan with a new one or a new HELOC. You could also refinance into a new and larger first mortgage—either a rate-and-term refinance or a cash-out refinance. With a rate-and-term refinance, you wouldn't be adding to your loan balance, unlike a cash-out refinance where you're tapping into your equity for additional funds.
Whether you lose equity when you refinance depends on the type of refinance you choose. With a rate-and-term refinance, you won't lose home equity because you're refinancing the principal balance on your mortgage and not borrowing against your home's equity. However, you may lose equity with a cash-out refinance because you're borrowing against your home's value. In this case, your home equity decreases by the amount you pull out.
A Cash-Out Refinance or Home Equity Loan Could Affect Your Credit
With a cash-out refinance or home equity loan, your lender may review your credit reports with a hard inquiry. Also, when your loan is added to your credit reports, the average age of accounts on your reports will decrease, and your loans will have a high balance relative to their original loan amount. These factors can all hurt your scores a little, but they're minor factors.
Your creditworthiness will factor heavily into your lender's decision to approve your loan and at what interest rate. Before applying, you might consider checking your credit report and credit score for free with Experian to see what lenders see when reviewing your credit. Taking steps to improve your credit score could raise it enough to qualify for a lower interest rate that may save you thousands of dollars over the life of the loan.