Cash-out refinance vs home equity loan: which is better?

If you need money and have a significant amount of home equity built up, you might want to access it for the funds. Using your home as collateral, you can tap into your home equity either through a cash-out refinance or a home equity loan.

But what’s the difference between a cash-out refinance vs home equity loan? Is it better to have equity or cash? And what’s risky about a cash-out refinance?

In this article, we will explore the differences as well as dive deeper into each option. Here is everything you need to know about cash-out refinance vs home equity loan.

What’s the difference between home equity and cash-out refinance?

Put simply, home equity loans are second loans, while cash-out refinances are first loans. A home equity loan is a separate loan from your mortgage and adds another payment. A cash-out refinance, on the other hand, pays off your existing home loan and gives you a new one.

Another key difference is that a cash-out refinance will give you a better interest rate. As mentioned, cash-out refinances are first loans, which means they will be paid first in the case of bankruptcy, foreclosure, or judgement. Because the risk to the lender is lower for first loans, typically the interest rates are lower as well.

To better understand the differences and similarities between home equity and cash-out refinance, let’s take a closer look at each.

Cash-out refinance vs home equity loan: Cash-out refinance

While there are different types of refinance, a cash-out refinance is essentially a new first mortgage. It enables you to take out in cash a portion of the equity that you have built in your house.

If you have had your home loan long enough that you have built home equity, you may be able to do a cash-out refinance. However, many homeowners can do a cash-out refinance if the value of their property has increased. In other words, if you think the value of your home has increased since you purchased it, you will likely be able to do a cash-out refinance.

How a cash-out refinance works

A cash-out refinance essentially means you are replacing your existing mortgage with a new mortgage. The loan amount on the new mortgage is more than the loan amount you owe on your current mortgage. You end up keeping the difference between your current mortgage loan balance and your new loan amount, after the loan funds are distributed. Note, however, that the money you keep is minus the equity you are leaving on your property, as well as other standard fees and closing costs.

Example of cash-out refinance  
Here is an example. Say your property is $200,000 and you owe $100,000 on your home loan. To take cash out, you often need to leave 20% equity (in this case, $40,000) in the property. If you wanted to refinance your property with a new $160,000 loan amount, you would receive $60,000 (minus the standard fees and closing costs). This also means, however, that your monthly payments would increase to make up the new loan amount.

Cash-out refinance vs home equity loan: Home equity loan

A home equity loan is a second loan. Separate from your mortgage, home equity loans enable you to borrow against the equity in your home.

A home equity loan does not replace your current home loan (which is unlike cash-out refinance). Rather, it is a second mortgage and carries with it another payment. And because it is a second payment, home equity loans usually have higher interest rates compared to first mortgages.

How a home equity loan works

Since home equity loans are entirely separate from your mortgage, the loan terms for your original mortgage will remain unchanged. After closing your home equity loan, your lender will provide you with a lump sum payment. This lump sum you will be expected to pay back, often at a fixed rate.

For a home equity loan, it is rare that a lender will allow you to borrow 100% of your equity. While it varies depending on the lender, the maximum amount that you can borrow is typically between 75% to 90% of the value of the property.

Like a cash-out refinance, the amount that you can borrow usually depends on your credit score, your loan-to-value (LTV) ratio, your debt-to-income (DTI) ratio, and other factors.

Cash out refinance vs home equity loan: Similarities

We have explored the differences between a cash-out refinance vs. a home equity loan, now let’s look into the similarities.

• Almost instant money. One similarity between the two is that you receive your money almost instantly. Whether you are getting a home equity loan or a cash-out refinance, you will receive a lump sum payment within three business days after you close.
• Borrow against equity. You borrow against the equity in your home. With both home equity loans and cash-out refinances, you use your home as collateral. This means, compared to other types of loans, you can get lower interest rates for home equity loans and cash-out refinances.
• Under 100% equity. Typically, you cannot take 100% equity from your home. Most loan types and lenders stipulate that you must leave some equity in the property.

Is it better to have home equity or cash?

Both home equity loans and cash-out refinances are strategic ways to access the equity you have built up in your home. Whether it is better to have home equity or cash will depend on your current financial situation and your financial goals.

You should also consider the qualification criteria for either option. This will help you determine which one you are more likely to get approved for.

On the one hand, a home equity loan would be great if you have a strong credit score and want to pull out a larger, fixed lump sum. A cash-out refinance, on the other hand, might be the smart option if you want to reduce your mortgage payment. It also enables you to pull funds from your equity by using a single loan product.

Let’s take a closer look at when it might be more beneficial to use a cash-out refinance vs home equity loan:

When to use cash-out refinance

A cash-out refinance may make the most sense for you if your property value has increased or if you have built up equity over time by making payments. A cash-out refinance is a low-interest approach to borrowing the funds you need for debt consolidation, home improvements, tuition, or other expenses. In other words, if you have major expenses you want to borrow funds for, cash-out refinancing can be a great way to pay for those expenses while minimizing the interest.

When to use a home equity loan

A home equity loan makes sense if refinancing your mortgage would force you to get a significantly higher interest rate. But keep in mind that the high interest rate that comes with home equity loans may not be worth it either. It is best to calculate beforehand to determine if a home equity loan makes financial sense for you. For instance, you may find that a home equity line of credit (HELOC) makes more sense.

Kyle Enright, President, Lending, at Achieve, told Mortgage Professional America in an interview that whether it’s better to have home equity or cash depends on several factors.

“One is how much equity you have in the home—and what you would use the cash proceeds from your home equity for,” Enright explained. “Depending on their location, many people who’ve owned their homes for some time have built up a large amount of equity. Consider that the national median home price in February 2020 was $270,100. Last month, it was more than $402,000. That’s close to a 50% increase in just three years.”

Enright added: “For homeowners who are carrying high-interest credit card and other debt—and who have substantial home equity—accessing that equity to pay off that debt could be a very smart move. Homeowners need to do the math to make sure that they are obtaining enough savings to make dipping into home equity worthwhile.

“Beyond paying off high-interest credit card debt, other uses for the funds can make good sense (e.g., medical expenses, home repairs, maintenance, renovations, remodels). For people without an emergency fund, using the funds to help build a fund can be a good idea.”

What is the downside of a home equity loan?

A home equity loan is just that: a loan secured by your home. That means you are taking on additional debt, which can affect credit profiles, Enright said. “It will definitely affect the budget, as you will have another monthly payment (along with your regular mortgage payment),” he added.

“Since a home equity loan uses the home as collateral, you run the risk of foreclosure if you do not keep up with payments. And should property values decline, and you have dipped into too much equity in your home, you may put your home at risk if you need to sell/move.”

Is a cash-out refinance risky?

There are many benefits to a cash-out refinance. However, there are risks as well. Here is a quick look at some of the risks that come with cash-out refinancing:

• Interest costs
• Closing costs
• Foreclosure risk
• Lost equity
• Time to close

Here is a closer look at each of the ways that a cash-out refinance can be risky:

Interest costs

A cash-out refinance loan usually has higher interest rates—although in most cases, only slightly higher—than your standard rate and term refinance. Mortgage lenders might charge you more for the added risk, since you are borrowing more money and reducing your home equity.

Additionally, extending the term of your home loan and borrowing more money usually increases the amount of interest you must pay over the life of the loan.

Read more: How soon can you do a rate and term refinance?

Closing costs

With a cash-out refinance, you will have to pay the usual closing costs. This includes everything from origination and underwriting fees to appraisal charges and title insurance. However, mortgage lenders often subtract these costs from the additional cash you are borrowing. Typically, closing costs are between 2% and 5% of the loan amount, which is between $2,000 and $5,000 for every $100,000 borrowed. While you might avoid closing costs or even get a credit at closing, you will likely pay a higher interest rate.

Foreclosure risk

Your property serves as the collateral for the cash-out refinance. If your new loan bumps your monthly repayments up, you may have a tougher time keeping up if your income drops or your expenses increase. This puts you at a greater risk of foreclosure than if you had not refinanced.

Lost equity

Your equity is reduced when you do a cash-out refinance. With reduced equity, you may be at greater risk of struggling to keep up with your loan. You also risk being unable to repay the loan if home values decrease and you are forced to sell.

Time to close

It can take time to close if you go with a cash-out refinance, sometimes several weeks. You may gain quicker access to money if you choose a personal loan or a credit card. If your interest rates are higher than home loans, they may be less costly if you repay them sooner than later. Why? You will not incur thousands of dollars in mortgage closing costs.

Cash out refinance vs home equity loan: closing thoughts

Whether you want a cash out refinance vs home equity loan will largely depend on your current financial situation and your financial goals. Both home equity loans and cash-out refinances are strategic ways to access the equity you have built up in your home. It is important to do research to determine what you may qualify.

Remember: the more knowledge you have, the better off you will be.

For help in getting the best deal on a cash-out refinance or home equity loan, get in touch with one of the mortgage professionals we highlight in our Best of Mortgage section. Here you will find the top performing mortgage professionals across the USA.

Did you find these tips useful? Do you have experience with a cash-out refinance or home equity loan? Let us know in the comment section below.