Cash-Out Refinance vs. A Home Equity Loan

By Realty Times Published May 30, 2023 09:54 am Updated May 30, 2023 10:00 am

When you have equity in your home, which is likely your biggest investment, you can use it to achieve other financial goals. A cash-out refinance is one way to get cash out of your house, as is a home equity loan. With both options, you can do various things with the money, like consolidating debt or renovating your home, but there are differences between the two approaches and pros and cons of each.

How Does a Cash-Out Refinance Work?
A cash-out refinance is a new mortgage and a first mortgage that lets you use the equity in your home to take out cash. If you’ve had your mortgage loan for long enough to build significant equity, you may have the option to do a cash-out refinance.

You’re most likely to be able to do a cash-out refinance if the value of your home goes up.

When you do a cash-out refinance, you’re replacing a current mortgage with a new one. As you might imagine, this isn’t an especially popular option currently, with such high interest rates that are continuing to go up.

The loan for your new mortgage is more than what you owe currently, and then once you receive your loan funds disbursement, you can keep the difference between the amount of the new loan and your current balance minus the equity you leave in your house, and any closing costs and fees.

Typically to take cash out of your home, you need to keep 20% equity in your home. Remember that your monthly payments will go up because you have a new loan amount.

With a cash-out refinance, you aren’t usually able to get a loan for the entire value of your house—many of these loans require you to keep some equity in your home.

If you want to qualify for an FHA and conventional loan, you have to keep 20% equity, and with a VA loan, you can get a loan for 100% of the value of your house, which is the only exception.

The cash you take out is tax-free; you can use it however you want.

What About a Home Equity Loan?
Home equity loans are a second loan separate from your first mortgage, and they let you borrow against the equity you’ve built in your home. You aren’t replacing your current mortgage, which is one of the big differences between this and a cash-out refinance, and it’s a second mortgage meaning an altogether separate payment.

The terms are separate from a home equity loan as well, but you are borrowing against your equity, which is the difference between the value of your home and what you owe on your first mortgage.

You might be eligible to borrow up to 85% of the equity in your home, but your income and credit history will play a role too.

The rates on a home equity loan can be higher compared to other similar options, and the repayment periods usually span up to 30 years. Mortgage insurance isn’t required but can be with some cash-out refinance mortgages, and there may not be origination fees.

If you have a lot of equity you’ve built up in your home, you might consider a home equity loan because you can borrow a larger amount of money, pay off your first mortgage and then put whatever’s left of your loan towards another goal or expense.

When we compare a cash-out refinance and a home equity loan side-by-side, the cash-out refinance loan would likely be cheaper because the interest rate will be lower. By contrast, a home equity loan comes with lower closing costs, but because you’re paying more interest over time, it will still be the more expensive option.

Many financial experts say it’s best to avoid taking out home equity loans for anything aside from projects that will impact your home equity directly, which is worth keeping in mind, especially in the current interest rate environment.