Today homeowners looking for cash out have a choice to refinance or take out a home equity loan in an effort to leverage the equity in their home for money. Let’s explore the pros and cons of a cash out refinance versus home equity loans.
In most cases, when the interest rate trend is upward, the market for home equity loans increases. When considering refinancing to receive cash you should make sure it makes sense to increase the interest rate and monthly payment. Sometimes, keeping your current mortgage and adding an equity loan is the prudent choice.
Which Is Best, a Home Equity Loan or Cash Out Refinancing?
Exploring cash out refinancing provides an opportunity to secure new mortgage rates and terms, along with the potential for a lump sum of cash. However, for those content with their current mortgage, home equity loans offer a potentially more cost-effective avenue for obtaining cash, because you can keep your existing low interest mortgage.
Your home is not just your castle. It can be a cash source for home renovations, repairs, college tuition, or an emergency fund. The equity you have built up can be tapped through a mortgage refinance or a home equity loan.
What’s the difference and which is better for you? These cash-out refinance and home equity terms are often discussed but it’s important to determine which type is loan is best for your situation.
Home Equity Loan vs Cash Out Refinance
Home equity loans and a cash-out refinance share a common goal in that they provide a means to secure funds for significant expenses like home remodeling, medical expenses, education costs, or consolidating revolving debt.
Despite this shared purpose, they each bring distinct advantages and drawbacks, catering to different situations.
A cash out refinance pays off the old loan and offers additional money that comes back with a new one with a higher loan amount.
A home equity loan gives you equity with a different mortgage loan, known as a second mortgage.
Cash out refinances are well-suited for individuals in a market when interest rates are low.
Today the mortgage rates are the highest they have been in 23 years, so unless the borrower has a high interest rate on their first mortgage above 6%, its unlikely that a cash out refinance makes sense. In an era of low interest, if a borrower needed of a substantial amount of funds for a specific purpose, such as significant home renovations, then cash out refinancing would be a wise choice.
In a time like this with high mortgage rates, it makes sense in most cases, to take out a home equity loan even if the interest rate is higher, because you can leave your low interest mortgage in tact. They are more appropriate for those seeking access to a financial reserve over an extended duration rather than in one lump sum.
What is the Difference Between a Home Equity Loan and a Cash Out Refinance?
What sets a home equity loan apart from a cash-out mortgage is their position on title. Cash out refinances replace your original mortgage with a new first mortgage, while home equity loans are considered a 2nd mortgage that entail an additional payment.
Typically, cash out refinance rates are more favorable compared to home equity loan rates.
In most cases, the rates on a cash out refinance will be 1% to 2% points lower than the rate on an equity loan.
We recommend adding your current mortgage payment to the proposed home equity loan payment.
Compare those combined payments to the prosed cash-out refinance payment. This will reveal the best solutions with the lowest monthly payment.
Refinancing Your Current Mortgage
There are two ways to do your mortgage refinance: rate and term refinance and cash out:
- A rate and term refi does not add to your loan amount, and you do not receive cashback. There are closing costs and fees, as with any new loan.
- The cash-out refinance loan gives you some of your equity as cash. You come from the closing table with a new, higher loan and a certified check with some of your equity.
Expect closing costs to be 2-3 percent of your new loan amount. On a refinance, you may need to pay taxes depending on your state and community. It is wise to live in the home for at least another year if you refinance your mortgage. Financial experts advise going with a rate and term refinance if you can recoup your costs in about 18 months with the lower interest rate.
Home Equity Loans
Home equity loans are second mortgages with lower rates than unsecured loans because your property backs them. That is the catch: If you do not pay the second mortgage, the lender can foreclose your home.
There are two types of home equity finance options: a regular home equity loan with a lump sum cash payment and a home equity line of credit.
A HELOC is similar to a credit card that is connected to the equity in your property. During the draw period after you receive the HELOC, you may borrow as much or as little as you wish, for the most part. Some loans require minimum withdrawals. Getting a low credit home equity loan may be more difficult to qualify for than refinancing.
You may need to pay a fee every time you pull out cash or a fee if you do not use the credit line during the draw period. During the five to 10 year draw period, you only are paying interest on what you borrow. When the draw period is over, your credit line is gone. You begin paying back the loan principal plus interest. Compare HELOCs and home equity loans. Both HELOCs and home equity loans are tax deductible in most cases.
A home equity loan and HELOC are often referred to as second mortgages or junior liens. You already have your first mortgage, and then you take out another loan against the equity built up in the home. The home equity loan is subordinate to the first mortgage. If you default, the second lender is behind the first lender to collect proceeds from the foreclosure.
Second mortgage interest rates are usually higher than cash out refinance rates because of their higher risk. Home equity loans usually have a fixed rate, but some are adjustable. HELOCs typically have flexible interest rates based on the Prime Rate or LIBOR Rate.
In contrast to unsecured loans such as credit cards and personal loans, home equity mortgages typically boast lower interest rates, ensuring more economical borrowing. Additionally, the interest rates on home equity loans remain fixed throughout the loan’s lifespan, simplifying monthly budgeting.
For those with ample equity, securing a larger sum is often more achievable with a home equity loan compared to similar mortgage options.
What Are the Drawbacks of a Home Equity Loan?
While home equity loans offer numerous benefits, it’s essential to be mindful of potential drawbacks. One significant concern is the risk of foreclosure. By securing a home equity loan, your home serves as collateral, implying that failure to meet payments could lead to the loss of your property.
Do you Need an Appraisal for a Home Equity Loan?
In most cases, taking out a home equity loan necessitates an appraisal. However, in some rare instances, a broker offers equity loans and HELOCs with a statistical appraisal which is quick and less expensive.
Most lenders require a full appraisal as a safeguard against the potential risk of default on the equity loan or cash-out refinance. In the event that a borrower is unable to sustain monthly payments in the long term, the lender seeks assurance that it can recover the loan’s cost through the appraisal mechanism. Learn more about getting a HELOC or home equity loan without an appraisal.
Refinancing or an Home Equity Loan?
You bought your home 10 years ago and the rates were 5% on a 30-year fixed mortgage. In 2024, you could get a new mortgage at 3.5%. Saving 1.5 points on your new mortgage can cut hundreds of dollars per month from your payment. It also will reduce your interest payments by thousands over the loan term. Back then, a cash out mortgage refinance could be your best option.
Today, in 2024, the 30-year rates are in the 6% range, so leaving your 3.5% alone and pulling out cash with an equity loan would be wise. In most cases, if you already have a first mortgage in the 3-4% range, but want cash to pay for a new kitchen or deck, a home equity loan could be a perfect choice.
You may opt for a home equity loan with a fixed rate if you like to know precisely your rate and when the loan will be paid in full. If you want a lower initial rate and are comfortable with the rate adjusting in the future, an equity line could be for you.
Can You Get a Home Equity Loan without Refinancing?
Certainly. You have the option to access your home’s equity without undergoing a refinancing process on your current mortgage. Home equity loans and Home Equity Lines of Credit (HELOCs) are commonly chosen alternatives that enable you to borrow against your home’s equity while preserving the original mortgage arrangement.
Cash Out Refinance Considerations
The ability to get a cash out refinance or a home equity loan largely hinges on your credit score. If your score has dropped since you bought your home, refinancing may not work because your interest rate could rise.
Check your credit from the three major credit bureaus before you apply for a cash out refinance. Talk to your cash-out mortgage lender if your credit score is not well above 700 to see how it may affect your rate. Learn how a cash out refinance works.
Getting a second mortgage requires you to submit documents to show you qualify. A home equity loan and HELOC can have the same closing fees as a first mortgage. Some of the closing costs include an appraisal, attorney fees, title search, and an application fee.
What Are the Drawbacks of Cash Out Refinances?
In most cases with a cash out refinance, the borrower is extending the term for 30-years. This can stretches the obligation and mortgage debt for years.
Like with any home loan, there is a risk of foreclosure. Your home serves as collateral for the refinanced mortgage. Failure to make timely payments on the new loan could lead to foreclosure. Postponing debt resolution: If you’re using the cash-out refinance to settle high-interest credit card debt, it’s crucial to carefully assess the long-term implications before proceeding.
Do You Forfeit Your Current Interest Rate When Cash Out Refinancing?
Yes, when you do a cash out refinance your existing mortgage is paid off and you loose your existing mortgage rate and it’s replace with a new interest rate that is attached to the cash-out refinance.
Though the interest rate on an equity loan or HELOC might be higher than what you’d encounter with a cash-out refinance, you won’t relinquish your existing mortgage rate, and the closing costs may not be as substantial. So this means if you presently have a low interest rate on your existing mortgage and you take out a home equity mortgage, you will be able to keep your preciously low rate.
Can You Use the Money You Receive for Whatever You Want in Cash-Out Refinance?
A cash-out refinance provides the flexibility to convert your home equity into cash by borrowing more than your existing loan, settling the previous balance, and keeping the surplus. Some lending underwriters will require the borrower to write a letter of explanation in regards to what they are using the cash out for in the refinance they are applying for. If the underwriter approves the loan, you have the liberty to utilize the funds for various purposes, whether it’s clearing credit card debt or renovating an outdated kitchen.
Can You Get an Equity Loan or HELOC without Refinancing?
Whether you opt for a home equity line of credit, a home equity loan, or engage in a sale-leaseback agreement, you have the opportunity to tap into your home’s equity without the need for cash-out refinancing. This financing flexibility extends to second homes and rental properties as well. Also ask about home equity investment loan that does not require you to refinance your primary mortgage.
Can You Minimize Taxes on a Cash-Out Refinance or Equity Loan?
You can employ the funds obtained from a cash-out refinance to enhance or fix a rental property under your management. These expenses can be deducted from your federal taxes. Almost invariably, any enhancements or repairs made to a property that you rent out qualify for tax deductions.
Find out if you borrowers are required to pay taxes on the money they receive in a cash out refinance transaction.
When Is a Home Equity Loan the Wise Choice?
A home equity loan proves advantageous if you presently enjoy a low interest rate on your mortgage, fulfill the credit prerequisites, and possess sufficient home equity to meet the eligibility criteria. It also serves as a viable option if you prefer to bypass the refinancing process for your mortgage.
Homeowners must, however, exercise caution, fully recognizing the associated risks of a home equity loan and committing to timely loan payments.
Can You Refinance a Home Equity Loan?
Yes, if you decide to take out a home equity loan and the interest rates drop, you can refinance it and replace it with a new equity loan. The other reason to refinance a home equity loan is in many instances homeowners don’t borrow enough money to meet their needs.
You can refinance a home equity loan, but you want to make sure you are improving the interest rate and accomplishing your goals.
When considering a home equity loan refinance, we suggest exploring a HELOC especially if you are remodeling your home. With a home equity line of credit you only pay interest on what you actually use.
When Is the Cash-Out Refinance the Best Move?
A cash-out refinance is deemed favorable in a couple of scenarios. Firstly, if there is a shift in the interest rate environment allowing you to secure a lower mortgage rate, a cash-out refinance may emerge as a more advantageous long-term option.
Additionally, opting for a cash-out refinance may grant access to more funds compared to home equity loans, which typically have borrowing limits. Similar to home equity mortgages, borrowers should only pursue a cash-out refinance if they can consistently meet their payments, especially when dealing with potentially larger payments associated with the new mortgage terms.
Ending the Debate on Home Equity Loans and Cash Refinancing
A mortgage refinance and second mortgages can help homeowners turn their equity into cash in hand. To decide the best option for you, think about your available equity, why you want the money, your credit score, and how long you intend to live in the home.
Home equity financing and cash out refinancing represent two avenues for tapping into the cash accumulated through homeownership. Both refinance and home equity lending programs offer solutions for significant expenses like home renovations, high-interest credit card payments, or funding college.
However, they diverge in certain aspects. A crucial shared principle is the potential risk of losing your property in a foreclosure if you fail to meet repayment obligations. This underscores the importance of careful consideration and financial planning before embarking on either a cash out refinance or home equity loan.
Speak with a trusted financial adviser before making a commitment.
About RefiGuide
Bryan Dornan is a financial journalist and currently serves as Chief Editor of RefiGuide.org. Bryan has founded several mortgage and marketing companies and has worked as a loan officer and mortgage broker in the industry for over 25 years and has a wealth of experience in providing mortgage clients with the highest level of service in the industry. Bryan's continual focus is to promote affordable home-ownership to consumers like you across the United States. He also writes for RealtyTimes, Patch, Buzzfeed, Medium and other national publications. Find him on Twitter, Muckrack, and Linkedin
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