Cash-Out Refinance Vs. Home Equity Loan: Which Is Right For You?

Cash-out refinance versus home equity loan: What are the differences? Most importantly, which option is right for you?

First, it's important to understand the basics of a refinance. Cash-out refinancing means tapping into the home equity you've built up, which is the amount you've paid off on your home after subtracting your mortgage balance and other liens.

Let's investigate a home equity loan versus a cash-out refinance so you zero in on the right option for you.

Understanding Cash-Out Refinances

In a cash-out refinance, you borrow against your home's equity. You get a new mortgage larger than your current mortgage balance and can borrow the difference between the two amounts. Lenders usually allow you to withdraw about 80% of your home equity, and you can use that money for whatever you choose, like putting a pool in, completing landscaping, debt consolidation, investment opportunities, emergencies, paying for college or other things you want.

Here's how it might work. Say you had $100,000 equity in your home (you paid your mortgage down to $200,000 from a $300,000 original purchase). You could withdraw 80% – $80,000. Let's say you needed that exact amount to do landscaping for your home.

In this example, you'd get a new mortgage by adding $80,000 – $200,000 to get your new mortgage amount – $280,000. Your lender would lend you $80,000 in cash to spend on your landscaping.

Note that you may need at least 20% of equity in your home to qualify but check your lender's requirements.

Learn more about home equity and how it works.

Cash-Out Refinance Pros

Consider the advantages of a cash-out refinance which include:

• Lower interest rates: Cash-out refinances can offer lower interest rates, especially compared to credit cards, personal loans and other types of debt. A lower interest rate can save you thousands over your loan term.
• Lump-sum payment: You can get a lump-sum payment as part of a refinance, which you can use for anything you want. If you don't have extra cash lying around, it's a great way to tap into a previously inaccessible cash stash. 
• One loan: A cash-out refinance offers you one loan, so you don't have to manage two separate loans. Your lender then gives you a brand-new loan with new monthly payments.
• Lower credit requirements: You must have a credit score of at least 580 to qualify for a refinance and typically 620 to take cash out (with some exceptions that allow for a 580 score). Your lender checks your credit score to ensure that you have a high likelihood of qualifying for and affording your loan.

Cash-Out Refinance Cons

It's worth considering the downsides before you choose a cash-out refinance:

• Higher closing costs: You may pay higher closing costs with a cash-out refinance compared to a home equity loan, which we'll discuss in the next section. However, you may get a better interest rate, so there are definite upsides and all angles.
• Risk of increased debt: When you tap into your home equity for a cash-out refinance, you also take on more debt because you raise your mortgage amount. (In our example in the second section, the borrower increased their mortgage amount from $200,000 – $280,000.)
• New loan terms: New loan terms can benefit you financially. For example, a cash-out refinance can give you a new interest rate or shorter or longer loan term. A lower interest rate and shorter loan term can save you thousands over the course of your loan. Refinancing to a longer loan term can net you a smaller monthly payment but might cost you more in the long run because of the added interest you pay each month. 
• Home acts as collateral: Your lender always needs a way to cover costs if you were to suddenly quit making payments. Your home serves as collateral, or in short, a guarantee of repayment. If you stop making payments, your lender can seize your home.

Understanding Home Equity Loans

A home equity loan, like a cash-out refinance, allows homeowners to borrow against the equity in their home.

However, here's the difference between cash out refinance and home equity loan: A home equity loan is a type of second mortgage. In other words, it doesn't replace your current mortgage. Instead, you make a second, separate payment. You can use a home equity loan for a wide variety of things – home improvements, debt consolidation, emergency expenses, education, wedding savings and more.

Home equity loans offer borrowers a lump sum of cash, and they must repay in monthly installments over a specific loan term, typically 10, 20 or 30 years. You'll make even, consistent payments during your loan term with a fixed interest rate, which means your interest rate doesn't change.

Learn more about second mortgages.

Home Equity Loan Pros

• Fixed interest rates: Home equity loans have fixed interest rates, which means the rate will stay the same during the life of the loan. Interest rates for home equity loans, just like cash-out refinances, are likely lower than other types of financing, including credit cards.
• No restrictions on use: You can use the money for the second mortgage however you'd like. Other types of loans put restrictions on how you can use them. For example, you can only use student loans to pay for school and nothing else, but you can use a second mortgage however you want.
• No change in existing mortgage terms: Your mortgage terms stay the same with a home equity loan, which can be a huge benefit if you like the terms of your current mortgage.
• Potential tax deductions: You can take advantage of a mortgage interest tax deduction – you can deduct up to $750,000 as a single filer or married couple filing jointly, while the limit is $375,000 for those married by filing separately.

Home Equity Loan Cons

The disadvantages of home equity loans include:

• Higher interest rates: Most people prioritize their first mortgage – their original mortgage – over their second mortgage. Therefore, home equity loans usually have higher interest rates than a refinance.
• Additional monthly payment: Paying on a second mortgage means that you'll make an additional monthly payment every month. You'll pay both your first mortgage payment and your second mortgage payment, which means you'll have to manage two payments, not just one.
• Risk of foreclosure: Defaulting on your second mortgage can result in foreclosure. Foreclosure occurs when a borrower can no longer make their mortgage payments and the bank repossesses the home and tries to resell the home.
• Original mortgage and home equity loan repayment at sale: You don't pay off just one mortgage when you sell your home with a home equity loan. You'd pay off two mortgages – your original (also called your "first" mortgage) and your home equity loan (also called your "second" mortgage).

Is It Better To Get A Cash-Out Refinance Or A Home Equity Loan?

Which is better, a cash-out refinance or a home equity loan? You'll need to consider a few angles before deciding between the two.

• Current mortgage terms: First, review your current mortgage terms. What is your interest rate? How long is your loan term? Evaluate whether you need to change your loan term or interest rate. You can change these with a refinance, not a second mortgage. If you like your interest rate and loan term, you may prefer a second mortgage instead, especially if your interest rate will increase with a refinance.
• Equity amount: Next, determine your current home equity amount for a cash-out refinance versus a home equity loan. Do you have at least 20% equity in your home (or the amount your lender requires)? It's important to consider how much equity you have before you apply.
• Your goals and needs: Ultimately, you should consider your goals and needs to ensure that you choose the right option. Also, consider where you stand with your current mortgage. For example, if you have a single mortgage, and your interest rate is higher than the current interest rate available, you may jump on that to save money over your loan term. Consider the breakeven point if you plan to move at some point – when would you start to make money on the deal?

Cash-Out Refinance Vs. Home Equity Loan: At A Glance

Let's look at a chart that can clearly outline the differences between cash-out refinances and home equity loans.

FAQs: Home Equity Loans Vs. A Cash-Out Refinance

Still have questions about whether you should go for a home equity loan or a cash-out refinance? Let's take a look at some lingering questions you may have.

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

In both a cash-out refinance and home equity loan, you borrow against your home's equity. In a cash-out refinance, you get a new mortgage larger than your current mortgage balance and receive the cash difference between the two amounts.

A home equity loan is a type of second mortgage. It doesn't replace your current mortgage – you make a second, separate payment.

How do I know how much equity I have?

You can figure this out easily – simply subtract your outstanding mortgage balance from the current market value of your property. For example, say your home's current market value is $300,000 and you owe $200,000 on your mortgage. Your equity is then $100,000. You can use an online refinance calculator or seek a professional appraisal to get a more accurate valuation.

Do you lose equity when you refinance?

Refinancing your mortgage doesn't have to cause you to lose home equity. In fact, it can be just the opposite. Refinances can allow you to get a new loan with lower interest rates, helping you to build equity faster and make repayments more easily.

Are there tax implications for either option?

Loan proceeds from a cash-out refinance and home equity loan are not taxable and not considered income.

If you itemize deductions, you can deduct the interest you pay on a home equity loan or cash-out refinance from your taxable income, subject to certain dollar limitations.

What can I do if I don’t qualify for a cash-out refinance or a home equity loan?

If you don't qualify for a cash-out refinance or home equity loan, consider increasing the equity in your home, improving your credit score, or stabilizing your income. Check with your lender to see what you need to do to meet the qualifications for a cash-out refinance or home equity loan. They can make suggestions to help you meet your goals.

FAQs About Home Equity Loans Vs. Cash-Out Refinances

Now that we've gone over what you need to know from a cost and fit perspective, let’s take a look at the following FAQs regarding cash-out refinances and home equity loans:

How can I tell how much equity I have in my home?

To determine how much equity you have in your home, subtract your outstanding mortgage balance from the current market value of your property. For example, if your home's current market value is $300,000, and you owe $200,000 on your mortgage, your equity would be $100,000. You can use an online refinance calculator or seek a professional appraisal for a more accurate valuation.

Will a home equity loan cost less than a cash-out refinance?

In general, home equity loans do have lower closing costs compared to cash-out refinances, making them more attractive from an upfront cost perspective. However, home equity loans may also have higher interest rates compared to cash-out refinances, which could result in higher long-term interest expenses. As a result, borrowers should carefully evaluate both the upfront costs and the long-term implications of each option before making a decision.

Are there restrictions on how I can use the money?

No, cash-out refinances and home equity loans generally have no restrictions on using the borrowed funds. Once you receive the money, you have the flexibility to allocate it towards any expenses or financial goals you deem necessary.

Can I still qualify for these loans if I don’t have tons of equity in my home?

In general, most lenders typically require homeowners to have at least 20% equity within the home before considering them eligible for a cash-out refinance or a home equity loan. However, it's important to note that specific lender requirements may vary, and some lenders may offer loans to borrowers with less, but it could result in different terms and conditions.

What can I do if I don’t qualify for a cash-out refinance or a home equity loan?

If you don't qualify for a cash-out refinance or a home equity loan, there are still alternative financing options available. You can explore personal loans, credit cards or home equity lines of credit (HELOCs) as potential solutions for your financial needs. Additionally, taking steps to improve your credit score and financial standing can increase your chances of qualifying for these loans in the future.

Is it better to refinance or get a home equity loan?

Whether to refinance or get a home equity loan depends on your specific financial goals and circumstances. If you have substantial equity in your home, a cash-out refinance might be more beneficial, as it allows you to access lower interest rates and potentially obtain a larger loan amount. On the other hand, if you prefer to keep your existing mortgage, a home equity loan can be a suitable choice, offering lower closing costs and a separate loan with its own terms. It's crucial to compare the costs, interest rates, etc., of both options to make an informed decision that best aligns with your financial objectives.

The Bottom Line

Is it better to refinance or get a home equity loan?

There's no one "right" answer. Research and weigh all your options to determine which option matches your situation and financial goals.

If a cash-out refinance fits your needs, start on an application today to see how much equity you can tap into.