Home Equity

Cash-out Refinance vs Home Equity Loan: Which Should You Choose?

April 27, 2020

Your home is more than just the place where you live. It’s an investment. Over time, your home accumulates value, and you can use the equity in your home to achieve your financial goals. Whether you’re looking to make home repairs, consolidate debt, pay for college, or give your business more working capital, a cash-out refinance or home equity loan may be able to help.

A cash-out refinance is a new mortgage with a loan for a greater amount than what you currently owe on your house. The loan helps you pay off the balance on your mortgage with leftover money for your own use.
A home equity loan is a loan in which you borrow against the equity that you’ve built up in your home. Often called a “second mortgage,” this option is an entirely separate loan with its own payment.

Cash-out refinancing and home equity loans are similar, but they also have significant differences and come with their own unique advantages and disadvantages. Here’s what you need to know about the two options to figure out the best solution for you.

Cash-Out Refinance vs. Home Equity Loan: How They’re Similar

Cash-out refinance and home equity loans share several similarities. Both loan options:

Allow you to tap into your home’s accumulated equity
Use your home as collateral, which helps you secure lower interest rates
Prevent you from taking 100% of the equity in your home—most lenders require you to leave some equity in the property and allow you to take up to 90%
Disperse funds immediately via a lump sum payment.

How They’re Different

While cash-out refinancing and home equity loans have their similarities, the two are very different loans:

A cash-out refinance:

Is a first mortgage—it replaces your existing mortgage with a new one
Pays off your current mortgage balance and leaves you with a remainder
Typically has a lower interest rate than a home equity loan
Tends to have longer terms. You may choose 15 to 30-year fixed-rate loans
Involves you paying for the loan’s closing costs

A home equity loan:

Is a second mortgage—you maintain your existing mortgage and the amount you borrow against the equity in your home is a new loan with its own payment. There are generally options to refinance a second mortgage as well
Is generally a smaller loan than a cash-out refinance
Has shorter terms ranging from 5 to 15 years
Involves lenders paying most, if not all, of the loan’s closing costs

Pros and Cons of a Cash-out Refinance

Pros

Since the loan replaces your existing mortgage, you only have to worry about one payment.
A cash-out refinance can lower the interest rate of your mortgage, helping you save potential thousands on interest over time.
Your interest is tax-deductible.
Using funds to consolidate high-interest credit cards and other debts can save you a substantial amount in interest.
A cash-out refinance is generally easier to qualify for since the loan is less risky—the lender has first claim to your property should you default.

Cons

Since you need to take out a new mortgage, your closing costs will be higher and you’re responsible for paying them. You can roll the costs into the loan, but doing this may result in a higher interest rate.
Refinancing your mortgage may extend the length of time you spend paying off your home.
If you have less than 20% equity in your home after your refinance, you need to take out private mortgage insurance.
Although the interest is tax-deductible, you can only deduct interest on the portion of the loan used to pay off your original mortgage—unless you use the remaining funds to make substantial home improvements

Pros and Cons of a Home Equity Loan

Pros

Rates for a home equity loan are much lower than rates for unsecured personal loans and credit cards.
Your rates and monthly payments are fixed, which means you won’t have any surprise increases in your payments.
A home equity loan allows you to keep your current mortgage’s interest rate.
Interest may be tax-deductible if you use the funds to make home improvements.
Closing costs are typically lower than those of cash-out refinancing. Your lender may also cover part of the costs.

Cons

A home equity loan is a second mortgage. It is separate from your current mortgage, which leaves you with two payments
While the lender gets a lien on your house, it takes second position. Your primary mortgage lender has first dibs on your home if you default on payments.
Home equity loans tend to be more difficult to qualify for.
If you don’t use the funds to make home improvements, your interest isn’t tax-deductible.

Cash-Out Refinance vs Home Equity Loan: Which Is Right for You?

The best option for you depends on your situation.

A cash-out refinance is the better choice for you if you:

Are looking to maintain a single payment.
Want to lower your current mortgage interest rate.
Have a significant amount of equity built up in your home and are looking for the lowest rates possible.
Need funds that are easy to qualify for.

On the other hand, a home equity loan makes more sense if you want to:

Tap into your home’s equity without altering your existing mortgage.
Avoid raising the interest rates you pay on your mortgage.
Avoid the additional cost of private mortgage insurance.

What if Neither Option Is Right?

In some situations, neither a cash-out refinance nor a home equity loan is the right choice for you. This doesn’t mean you’re out of luck. If neither option fits your situation and needs, a sale-leaseback may have the answer.

With a sale-leaseback program, you can get the money you need by selling your home. The best part is that you don’t have to move! You can stay in the home as a renter with the cash you need.