Cash-Out Refinance vs. Home Equity Loan

Article Summary:

Using the equity you’ve built in your home can be a great way to finance major expenses in your life, such as home improvements. Two ways to leverage that equity are to take out a home equity loan or to get a cash-out refinance. A home equity loan is basically a second mortgage on your home, whereas a cash-out refinance involves paying off your existing loan and replacing it with a new mortgage.

You may have been paying off your mortgage for a long time, or you may have made improvements to your home, increasing its market value significantly. Either way, you have some equity in the house and you want to be able to use that money for some projects you have in mind.

Perhaps you want to send your kid to college without saddling them with student loans, pay off your high-interest credit cards, or put a patio or pool in your backyard. In any case, cash-out refinancing or home equity loans could be the answer you’re looking for. There are advantages and disadvantages to either approach, so let’s take a look at both before you decide for yourself which one is right for you.

What is a cash-out refinance?

If you choose to go with cash-out refinancing, you’ll be taking out a new loan that replaces your existing mortgage, and you’ll receive a check for the loan amount you are allowed to borrow.

How much equity you can borrow depends a lot on your lender. Generally, lenders will not allow you to take out more than 80% of your home’s equity, but that amount can vary. Also keep in mind that with cash-out refinancing, you may be required to pay mortgage insurance if you don’t maintain a minimum of 20% equity in the house after the refinance.

Each particular lender’s requirements differ, but the amount you can get usually depends on your income and the health of your credit report. Additionally, mortgage refinancing will depend on your home’s loan-to-value ratio and your personal debt-to-income ratio (DTI). Even if your credit score is good, you might not be approved if you have more than a 50% DTI.

A cash-out refinance mortgage, sometimes colloquially called a “cash-out-refi,” is usually best for homeowners with a lot of equity in their home, who have an excellent credit history, and who want the cash for a big project or investment.

Pros and cons of cash-out refinance

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks to consider.

Pros
  • You receive a lump sum of cash based on how much equity you have in the home.
  • You can use that money for whatever you want.
  • It’s considered a “first mortgage,” so you may pay a lower mortgage rate than with a home equity loan.
  • You’ll have only one monthly mortgage payment to manage.
Cons
  • The principal on your new mortgage will be higher than your current mortgage balance, which will likely cause your mortgage payments to increase.
  • The higher principal may also cause you to pay higher interest rates than on your previous mortgage.
  • You will likely have to pay closing costs.
  • Your house is used as collateral, which can leave you vulnerable to foreclosure.

What is a home equity loan?

Home equity loans differ from cash-out refinances in that you are essentially taking out a second mortgage on your home. The loan against your equity is a completely separate loan from your first mortgage and comes with its own interest rate, terms, and conditions. On top of that, you will also have to deal with the burden of two monthly mortgage payments.

You can generally get a home equity loan with a relatively lower credit score than for a cash-out refi. However, you will still need to have a good credit history and prove sufficient income to manage the home equity loan plus your current mortgage. This puts you at a higher risk because you are beholden to two creditors instead of just one.

The mortgage lenders who supply home equity loans are subsequent to your first mortgage holder. This means if you default on your loans, the primary mortgage gets paid first.

Pros and cons of home equity loans

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks to consider.

Pros
  • You can get a large lump sum of money to be used for home projects or other financial goals.
  • It can be easier to get home equity loans than cash-out refinances.
  • Because of a potentially lower interest rate and a smaller principal, your second loan will likely come with a lower payment than your first mortgage.
  • Home equity loans are usually cheaper to get than cash-out refinancing.
Cons
  • You are now responsible for making payments on your second mortgage along with your primary mortgage, leaving you vulnerable to two different creditors.
  • Your house is used as collateral, which can leave you susceptible to foreclosure.
  • You might not be able to get a home equity loan if you have poor credit or insufficient income.

Cash-out refinance vs. home equity loan

So which option is right for you? As stated, both cash-out refinancing and home equity loans allow you to tap the equity in your home for any purpose. Each option also uses your house as collateral, meaning it opens you up to possible foreclosure if you can’t make your monthly payments on either loan for whatever reason.

The biggest difference between the two is that with cash-out refinancing, you are swapping out your original mortgage for an entirely new loan, meaning you will only have a single monthly mortgage payment. A home equity loan, on the other hand, is a second mortgage on top of your first mortgage, which means you will have two monthly payments to manage. This is a major factor to consider in your decision-making process.

Additionally, a home equity loan is typically less expensive than a cash-out refinance because of lower closing costs (which some lenders might waive) and lower interest rates. Plus, you can usually get by with a lower credit score than is required for cash-out refinancing.

Because cash-out refinance mortgages saddle you with a bigger mortgage loan than you had previously, you are looking at higher interest rates and a potentially bigger monthly payment. Your closing costs will likely be higher as well, since you are taking out an entirely new loan.

Which option you choose really depends on your individual financial needs and goals, as well as your credit history and income. Either way, you should talk to multiple lenders to get the best deal possible.

Alternatives to cash-out refinance and home equity loans

It’s important to assess your financial situation and ask yourself what exactly your reasons are for either taking out a home equity loan or undergoing a cash-out refinance. If, for example, you only need a small amount of money or you would like to take advantage of lower interest rates, you have a few other options at your disposal.

Shared equity agreements

A shared equity agreement, also known as a shared appreciation, is a financial agreement that allows another party to invest in your property and acquire a stake in its future equity. It’s important to understand that although they share some similarities, shared equity agreements are not mortgages. In fact, they aren’t technically loans. For this reason, their credit and income requirements are often lower than traditional home financing products.

With shared equity agreements, you won’t have to make any monthly payments on the amount, nor pay any interest. When the term is up, whether triggered by a set number of years or the sale of the home, you’ll repay your investor. How much you pay depends on whether your property’s value went up or down. Here are some home equity investors to consider.

Conventional refinance

Sometimes called a rate-and-term refinance, a conventional refinance doesn’t involve the homeowner receiving any money. In fact, no cash (other than closing costs) changes hands in a traditional refi. This type of refinancing is best if the interest rates are lower than what you’re currently paying and you are looking for smaller monthly payments.

For example, if your current mortgage comes with a 5% interest rate but you can get a new mortgage loan at a 3% interest rate, mortgage refinancing might be worth considering. The savings you’ll get from paying less interest over the life of the loan should more than cover closing costs and fees (some of which may be waived by the lender). Plus, having a lower monthly payment will free up a little cash each month, which could go toward paying down debts or saving for other financial goals.

0% credit cards

Many credit cards offer introductory interest rates of 0% for up to 24 months, which could make them a more viable option for you than refinancing or taking out a new loan.

Say you want to put a deck on your house or remodel a small bathroom, and you estimate that either project will cost you about $5,000. If your credit report is good enough to get you approved, a credit line might be worth considering, so long as you’re confident you can pay off the card before the introductory rate reverts to a high interest rate. In this case, a 0% credit card could be a quicker, less expensive, and more sensible choice for you than a mortgage refinance or a home equity loan.

Personal loan

Another option if you are only looking to borrow a small amount of money is to take out a personal loan. Costs for a personal loan are typically less expensive than refinancing your home while still giving you some time to pay the loan back.

Keep in mind that because a personal loan is usually unsecured, you’ll typically pay a higher interest rate than with a secured loan. However, if you’re sure you can pay off that loan relatively quickly, it may be a convenient way to get some cash without having to use your home as security.

Pro Tip

Get a free copy of your credit report before applying for new loans. If your credit isn’t great, there are steps you can take to improve your credit score, which will help to ensure you qualify for the loan or refi you want.

Applying for home equity loans or cash-out refinances

Before you do anything, request copies of your credit reports from the three major credit bureaus — Experian, Equifax, and TransUnion. You can get a free copy every year at AnnualCreditReport.com. It’s good to know where you stand before applying for a loan or refi, and you can also check for any inaccurate and/or fraudulent data on your report.

Once you have a better idea of your credit, you can start reaching out to lenders. In this competitive marketplace, every lender wants your business, so they should be able to tell you which option you’re most likely to qualify for and whether a cash-out refinance or a home equity loan makes more sense for you.

Also keep in mind that for either option, you will have many of the same expenses and will need to supply much of the same paperwork as you would for a first mortgage. Factors to consider include attorney and appraisal fees, title searches, and application or origination fees.

FAQ

What about a HELOC?

If you need access to a large amount of cash right away but don’t have a big project in mind, a home equity line of credit (HELOC) might be a good choice for you. A HELOC is another way to leverage the equity in your home, but unlike a traditional home equity loan, it works as a revolving line of credit rather than a lump sum disbursement. You can use as much or as little credit as you like without necessarily having to pay back the full amount.

A home equity line of credit allows you a draw period of up to 10 years before you need to start paying back the principal (you are only required to make interest payments during the draw period). Once you enter your repayment period, however, your payments will increase significantly because you’ll be paying down the principal as well. HELOCs also typically come with variable interest rates, which means your payments will fluctuate.

Do I have to pay taxes on cash-out refinances?

No. Despite the fact that you get a lump sum of money from a cash-out refinance, it is not considered income, so you are not taxed on it. It’s considered a loan, and therefore it is not subject to taxes.

Can I use a cash-out refi for investing purposes?

In most cases, homeowners will get a cash-out refinance to remodel their house or make major home improvements, which can considerably increase the value of their house. Homeowners may also use a cash-out refi for expenses not related to home improvement, such as debt consolidation or college tuition.

Some savvy investors may see an opportunity to cash out that home equity and roll it into an investment property. This could be a vacation home, a rental property, or even an Airbnb rental. If this sounds like an interesting opportunity, you should talk to a financial advisor to see if this may be a good option for you.

What is the catch to a cash-out refinance?

The catch is that while you just received a pile of cash to use at your discretion, you now have a larger loan than your original mortgage, which likely comes with a higher monthly payment — unless you timed your application with changes in the market just right and got a significantly lower interest rate.

The other obvious catch is that this mortgage refinancing still uses your home as collateral. If you can’t make your monthly payments, you could potentially lose your house.

Can you take equity out of your home without refinancing?

Yes, but not without going through essentially the same process as refinancing. Technically, getting a home equity loan or a home equity line of credit is not considered refinancing because each is a separate loan from your existing mortgage (although they still require your house as collateral). Ultimately, there is no quick and easy way to just tap the equity in your home without going through the whole application/approval process.

Key Takeaways

  • A home equity loan and a cash-out refinance are both ways to convert the equity you’ve built up in your home into cash.
  • A cash-out refinance replaces your existing mortgage with a new loan that exceeds the amount you owed on your original mortgage.
  • A home equity loan is a separate loan from your current mortgage — a second mortgage, basically — with its own interest rate, terms, and conditions.
  • Cash-out refinancing is usually more expensive than a home equity loan, but at the end of the day, you only have a single mortgage payment to worry about.
  • Conversely, a home equity loan can be less expensive than a cash-out refinance, but you are now stuck with two monthly mortgage payments.
  • Less stringent credit score requirements and underwriting procedures may make it easier to qualify for a home equity loan than for a cash-out refinance.
View Article Sources
  1. Search results: Cash-Out Refinance – U.S. Department of Housing and Urban Development
  2. Section B. Maximum Mortgage Amounts on No Cash Out/Cash Out Refinance Transactions – U.S. Department of Housing and Urban Development
  3. Single-Family Housing Policy Handbook, Module 6: Programs and Products – Refinance – U.S. Department of Housing and Urban Development