There are many benefits to being a homeowner. In addition to having the ability to customize your property and enjoy more privacy, you also build equity over time. This equity can be tapped in the form of a financing vehicle, like a home equity loan or cash-out refinance. That begs the question: When sizing up a potential home equity loan vs. cash-out refinance, which is better?
The answer requires taking the time to understand how cash-out refinance and home equity loans work, as well as understanding the closing costs involved, the different requirements imposed by lenders, the varied interest rates charged, and the numerous other financing alternatives available – including a home equity line of credit (HELOC).
How home equity loans and cash-out refinances work
A cash-out “refi” and a home equity loan both accomplish the same thing: They enable you to extract equity from your home that can be liquidated as cash. This money can be used to fund important goals, such as financing a costly home improvement project, paying down medical bills, funding college tuition, consolidating high-interest debt, or even making an expensive wedding happen. Yet home equity loans and cash-out refinances also work a bit differently.
Home equity loans
A home equity loan is a second mortgage. It is separate from your primary mortgage loan. A home equity loan is a form of financing that permits homeowners to borrow against the equity they have built up in their homes.
Equity is the difference between a residence’s current market value and the unpaid balance owed on the residence’s mortgage loan. This means that if you are eligible for a home equity loan, you can borrow up to 85% of your home’s value (depending on the lender), after subtracting any outstanding mortgage debt.
To secure the loan, you use your home as collateral. Consequently, if you don’t pay your home equity loan back on time and in full, the lender can foreclose on your home to recoup its losses. Although you can select an adjustable rate home equity loan, most borrowers opt for a loan with a fixed rate of interest.
When you opt for a cash-out refinance, you replace your existing primary mortgage loan with a new, larger, mortgage loan. The difference between these two loans, minus any closing costs charged, gets distributed to you as cash at “closing” (i.e., after finalizing the loan). But remember: this cash you receive is being borrowed, which is why your new mortgage loan balance will be higher than the one it replaced. Most borrowers select a cash-out refinance with a fixed interest rate. Ideally, the new interest rate is lower than the interest rate on your existing mortgage loan.
As with a home equity loan, your home is used as collateral on a cash-out refi.
Differences between a home equity loan and cash-out refinance
A cash-out refi and home equity loan both accomplish the same purpose: You pull out equity from your home and receive the funds, paid as a lump sum shortly after closing. Also, they both require you to use your home to secure the financing and maintain a minimum amount of equity in your home after closing the loan (usually 20%). Both permit you to access a large amount of cash quickly and use the money for nearly any legal reason.
“And the interest payments for each can be tax-deductible. If you use the proceeds for significantly improving your home, you might be able to deduct interest payments from your taxable income,” says Gunner Davis, a real estate broker with Coldwell Banker Realty in Tampa, Florida.
The major difference between the two, however, is that with a cash-out refinance, you replace your existing primary mortgage loan with the new primary mortgage loan with a larger balance. By contrast, a home equity loan is a second mortgage loan that is separate — and on top of — your existing primary mortgage loan.
“A cash-out refi is better for someone interested in changing the terms of their existing mortgage. A home equity loan is often better for someone who simply needs access to a lump sum of capital for certain expenses,” notes Dennis Shirshikov, a strategist for Awning.com and a professor of economics and finance at City University of New York.
But there are also other distinctions between the two types of loans, as outlined below.
Pros and cons of a home equity loan
Compared with a cash-out refinance, the benefits of choosing a home equity loan often include:
- Lower closing costs than a cash-out refinance.
- More flexible repayment periods, typically anywhere from 5 to 30 years.
- The ability to borrow up to 85% of the value of your home. A cash-out refi usually only lets you borrow up to 80%.
Meanwhile, the disadvantages of a home equity loan may include:
- A higher fixed interest rate, which means the loan will be more costly over time.
- Higher monthly payments if the lender requires a shorter repayment period.
Pros and cons of a cash-out refinance
Compared with a home equity loan, the benefits of a cash-out refinance often include:
- A lower interest rate.
- The ability to reset your primary mortgage loan, which allows you to choose a longer repayment term and pay less each month.
Meanwhile, the disadvantages of a cash-out refinance can include:
- Higher closing costs, often 2% to 5% of the loan amount.
- A longer repayment term, which means you may pay more in total interest over the life of the loan.
- The ability to only borrow up to 80% of your home’s value, compared with up to 85% for a home equity loan.
Qualifying: Which is easier?
It may be easier to qualify for a cash-out refinance than a home equity loan. The reason is that lenders view a second mortgage (home equity loan) as riskier than a primary mortgage (cash-out refi).
Lenders of primary mortgages are paid before lenders of second mortgages in the event of bankruptcy, foreclosure, or other financial judgment. And because a cash-out refinance is regarded as a less risky loan, lenders usually charge a lower interest rate for it than for a home equity loan.
Still, you’ll need to meet specific criteria to be eligible for either a cash-out refi or home equity loan, including:
- A sufficient credit score. Many lenders require at least a 580 credit score, while others require a 620 or higher score.
- A favorable debt-to-income (DTI) ratio. Aim for a DTI of 43% or less.
- Sufficient equity. Many lenders require you to keep at least 20% equity in your home following a cash-out refinance or home equity loan closing.
- Financial proof. Prepare to provide key documents the lender may request, including paystubs, proof of employment, W-2s, financial statements, and more.
- Waiting for your primary mortgage loan to season. Your lender may require you to wait at least six months from the time a new loan was created before receiving either type of additional financing.
- Paying for a new appraisal to determine the value of your home.
How much can you borrow?
Home equity loan
With a home equity loan, you may be permitted to borrow up to 85% of your home’s value, minus any outstanding mortgage balance. In other words, first, multiply your home’s value by 85%. Next, take the resulting amount and subtract your outstanding mortgage balance from it. The answer gives you the size of your home equity loan.
“Let’s say your home is worth $250,000, and you have an outstanding mortgage balance of $150,000. In this case, you could potentially borrow up to $62,500 [= (85% x $250,000) - $150,000] through a home equity loan,” explains Joshua Haley, founder of Moving Astute.
With a cash-out refi, on the other hand, you can borrow up to 80% of the value of your home.
“So, using the previous scenario where your home is valued at $250,000 and you have an outstanding mortgage balance of $150,000, a cash-out refinance would allow you to borrow up to $50,000 [= (80% x $250,000) - $150,000]” adds Haley.
Which is cheaper: a home equity loan or a cash-out refinance?
Home equity loans commonly charge lower fees and closing costs than cash-out refinances. However, you’ll likely pay a higher interest rate with a home equity loan. In other words, the upfront costs will be lower, but the total costs of the loan — when factoring in total interest paid over the life of the loan — may be higher with a home equity loan. The latter is true unless you choose a shorter repayment term for a home equity loan than you would for a cash-out refinance loan. Either way, the longer your borrowing term, the more total interest you will pay on either loan.
What are good alternatives to a home equity loan or cash-out refinance?
Instead of a home equity loan or cash-out refi, consider:
(1) A home equity line of credit (HELOC). A HELOC is a type of revolving credit, like a credit card, with a variable interest rate. You use your home’s equity as collateral in exchange for obtaining a revolving line of credit from a lender, from which you can borrow as needed and repay your balance;
(2) A personal loan, which can be easy to qualify for and doesn’t use your home to secure the loan, but often charges higher interest rates.
Do you lose equity when you refinance?
When you opt for a cash-out refinance, you can extract up to 80% of your home’s value in the form of cash taken out at closing. Any liquidated equity reduces the equity you’ve accrued in your home. Most lenders require you to maintain a buffer of at least 20% equity in your home after a cash-out refi.