Cash-Out Refinance vs. Home Equity Loan: An Overview
Your home is not just a place to live, and it is also not just an investment. It's both, and more. Your home can also be a handy source of ready cash to cover emergencies, repairs, or upgrades. The process of releasing the money you've invested in your mortgage is called mortgage refinancing, but there are several ways to do this.
A cash-out refinancing pays off your old mortgage in exchange for a new mortgage, ideally at a lower interest rate. A home equity loan gives you cash in exchange for the equity you've built up in your property, as a separate loan with separate payment dates.
- Cash-out refinancing and home equity loans both provide homeowners with a way to get cash based on the equity in their homes.
- Cash-out refinancing can be ideal if you intend to stay in your home for at least a year and your interest rate will drop, resulting in lower monthly payments.
- Cash-out refinancing is ideal for borrowers requiring a substantial sum of money for a specific purpose, such as a major home improvement.
- Home equity loans, by contrast, use your equity as collateral for an entirely new loan. They are suited to individuals who need access to a reserve of cash over a period of time rather than upfront, and also come in several types.
The Big Picture: Types of Refinancing
First, let's cover the basics. Both cash-out refinancing and home equity loans are types of mortgage refinancing. There are several other types of mortgage refinancing, and you need to consider whether refinancing is appropriate for you before looking at the differences between cash-out refinancing and home equity loans.
At the broadest level, there are two common methods for a mortgage refinance, or refi. One is a rate-and-term refinance, in which you effectively swap your old mortgage for a new one. In this type of refinancing, no money changes hands, other than costs associated with closing and funds from the new loan paying off the old loan.
The second type of refi is actually a collection of different options, each of which releases some of the equity in your home:
- A cash-out refinance effectively pays out some of the equity in your home as cash—you emerge from the closing with a new mortgage and a check for cash.
- A home equity loan gives you cash in exchange for the equity you've built up in your property as a separate loan.
In this article, we'll look at these two types of mortgage refinancing.
So why would you want to refinance your mortgage? Well, there are two main reasons—lowering the overall cost of your mortgage or releasing some equity that would otherwise be tied up in your house.
Let's say that 10 years ago, when you first purchased your home, interest rates were 5% on your 30-year fixed-rate mortgage. Now, in 2021, you can get a mortgage at an interest rate of 3%. Those two points can potentially knock hundreds of dollars a month off your payment and even more off the total cost of financing your home over the term of the loan. A refinance would be to your advantage in this case.
Even if you are happy with your mortgage repayments and term, it can be worth looking into home equity loans. Maybe you already have a low interest rate, but you’re looking for some extra cash to pay for a new roof, add a deck to your home, or pay for your child's college education. This is a situation in which a home equity loan might become attractive.
Pros and cons of refinancing
Before you look at the different types of refinancing, you need to decide whether refinancing is right for you. There are several advantages to refinancing. It can provide you with:
- A lower annual percentage rate (APR) of interest
- A lower monthly payment
- A shorter payoff term
- The ability to cash out your equity for other uses
However, you shouldn't see your house as a good source of short-term capital. Most banks won’t let you cash out more than 70% of the home’s current market value, and the costs of refinancing can be significant.
The mortgage lender Freddie Mac suggests budgeting about $5,000 for closing costs, which include appraisal fees, credit report fees, title services, lender origination/administration fees, survey fees, underwriting fees, and attorney costs. Closing costs are likely to be 2% to 3% of your loan amount for any type of refinancing, and you may be subject to taxes depending on where you live.
With any type of refinancing, you should plan to continue living in your home for a year or more. It can be a good idea to do a rate-and-term refi if you can recoup your closing costs with a lower monthly interest rate within about 18 months.
If you’re not planning to stay in your home for a long period of time, refinancing might not be the best choice; a home equity loan might be a better choice because closing costs are lower than they are with a refi.
What Is a Cash-Out Refinance?
A cash-out refinance is a mortgage refinancing option in which an old mortgage is replaced with a new one with a larger amount than was owed on the previously existing loan, helping borrowers use their home mortgage to get some cash. You usually pay a higher interest rate or more points on a cash-out refinance mortgage, compared to a rate-and-term refinance, in which a mortgage amount stays the same.
A lender will determine how much cash you can receive with a cash-out refinance, based on bank standards, your property’s loan-to-value ratio, and your credit profile. A lender will also assess the previous loan terms, the balance needed to pay off the previous loan, and your credit profile. The lender will then make an offer based on an underwriting analysis. The borrower gets a new loan that pays off their previous one and locks them into a new monthly installment plan for the future.
Pros and cons of a cash-out refinance
The primary advantage of a cash-out refinance is that the borrower can realize some of their property's value in cash.
With a standard refinance, the borrower would never see any cash in hand, just a decrease to their monthly payments. A cash-out refinance can possibly go as high as an approximately 125% loan-to-value ratio. This means the refinance pays off what they owe, and then the borrower may be eligible for up to 125% of their home’s value. The amount above and beyond the mortgage payoff is issued in cash just like a personal loan.
On the other hand, cash-out refinances have some drawbacks. Compared to rate-and-term refinancing, cash-out loans usually come with higher interest rates and other costs, such as points. Cash-out loans are more complex than a rate-and-term and usually have higher underwriting standards. A high credit score and lower relative loan-to-value ratio can mitigate some concerns and help you get a more favorable deal.
Home Equity Loans
Home equity loans are one option when it comes to refinancing. These loans tend to have lower interest rates than personal, unsecured loans because they're collateralized by your property, and that's the catch: The lender can come after your home if you default.
Home equity loans also come in two flavors: the traditional home equity loan, in which you borrow a lump sum, and the home equity line of credit (HELOC).
A traditional home equity loan is often referred to as a second mortgage. You have your primary mortgage, and now you're taking a second loan against the equity you've built in your property. The second loan is subordinate to the first—should you default, the second lender stands in line behind the first to collect any proceeds due to foreclosure.
Home equity loan interest rates are usually higher for this reason. The lender is taking a greater risk. HELOCs are sometimes referred to as second mortgages as well.
A HELOC is like a credit card that's tied to the equity in your home. For a set time period after you receive it, known as the draw period, you can generally borrow as little or as much of that credit line as you want, although some loans do require an initial withdrawal of a set minimum amount.
You may be required to pay a transaction fee each time you make a withdrawal or an inactivity fee if you don't use your credit line at any time during a predetermined period. During the draw period, you pay only interest on what you've borrowed. When the draw period ends, so does your credit line. You start paying back the principal plus interest when the repayment period kicks in.
All home equity loans generally have a fixed interest rate, although some are adjustable, while HELOCs typically have adjustable interest rates. The APR for a home equity line of credit is calculated based on the loan's interest rate, while the APR for a traditional home equity loan generally includes the costs of initiating the loan.
Pros and cons of home equity loans
There are several advantages to home equity loans that can make them attractive options for homeowners looking to reduce their monthly payments and simultaneously release a lump sum. Refinancing with a home equity loan can offer:
- Lower, fixed interest rates than your previous mortgage
- Lower monthly payments due to lower interest rates and a smaller principal
- A lump sum that can be used for any purpose, including renovations and improvements to your property that, in turn, can raise its value
On the other hand, home equity loans come with risks that you should be aware of:
- Your home secures the loan, so your home is at risk if you fall behind on your loan repayments.
- With a traditional home equity loan, you have to borrow a set amount of money. If you don't end up needing the whole amount, you can be stuck paying interest on a portion of the loan you don't use. This is why HELOCs are a better option for homeowners who need to cover ongoing, unpredictable expenses.
- You can’t get a home equity loan with too much debt or poor credit. This bars some people from being able to access the equity in their homes.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau and/or with the U.S. Department of Housing and Urban Development (HUD).
Cash-Out Refinance vs. Home Equity Loans
There are several reasons why you might choose a cash-out refinance over a home equity loan.
In principle, a cash-out refinance gives you the quickest access to the money you've already invested in your property. With a cash-out refinance, you pay off your current mortgage and enter
into a new one. This keeps things simple and can release a great deal of cash very quickly—cash that can even help improve your property's value.
On the other hand, cash-out refinancing tends to be more expensive in terms of fees and percentage points than a home equity loan is. You will also need to have a great credit score in order to be approved for a cash-out refinance because the underwriting standards for this type of refinancing are typically higher than for other types.
A home equity loan is easier to obtain for borrowers with a low credit score and can release just as much equity as a cash-out refinance. The cost of home equity loans tends to be lower than cash-out refinancing, and this type of refinancing can be far less complex.
Home equity loans also have drawbacks, though. With this type of refinancing, you are taking out a second mortgage in addition to your original one, meaning that you now have two liens on your property, which translates to having two separate creditors, each with a possible claim on your home. This can increase your risk level and is not recommended unless you are certain you can make your mortgage payments on time every month.
Applying for Mortgage Refinancing
Your ability to borrow through either cash-out refinancing or a home equity loan depends on your credit score. If your score is lower than when you originally purchased your home, refinancing might not be in your best interest because this could quite possibly increase your interest rate. Get your three credit scores from the trio of major credit bureaus before going through the process of applying for either of these loans. Talk with potential lenders about how your score might affect your interest rate if they're not all consistently over 740.
Taking out a home equity loan or a home equity line of credit demands that you submit various documents to prove that you qualify, and either loan can impose many of the same closing costs a mortgage does. These include attorney fees, a title search, and document preparation.
They also often include an appraisal to determine the market value of the property, an application fee for processing the loan, points—one point is equal to 1% of the loan—and an annual maintenance fee. Sometimes lenders will waive these, however, so be sure to ask about them.
Refinancing and home equity loan FAQs
Do You Lose Equity When Refinancing a Home?
The equity that you built up in your home over the years, whether through principal repayment or price appreciation, remains yours even if you refinance the home. Though your equity position over time will vary with home prices in your market along with the loan balance on your mortgage or mortgages, refinancing in itself won't affect your equity.
What Is a Cash-Out Refinance?
A cash-out refinance is a type of mortgage refinance that takes advantage of the equity you've built over time and gives you cash in exchange for taking on a larger mortgage. In other words, with a cash-out refinance, you borrow more than you owe on your mortgage and pocket the difference.
Do I Have to Pay Taxes on a Cash-out Refinance?
Not normally. You do not have to pay income taxes on the money you get through a cash-out refinance. The cash you collect from a cash-out refinance isn't considered income. Therefore, you don't need to pay taxes on that cash. Instead of income, a cash-out refinance is simply a loan.
The Bottom Line
Cash-out refinancing and home equity loans can benefit homeowners who want to turn the equity in their homes into cash. To decide which is the best move for you, consider how much equity you have available, what you will be using the money for, and how long you plan to stay in your home.