Unlocking Home Equity: Cash-Out Refinance vs. Home Equity Loan

If you have built up substantial equity in your home, you might be considering tapping into it to fund your goals, such as completing a remodel, paying for education, or consolidating high-interest debt. Two popular options to access this equity are a cash-out refinance and a home equity loan. But what’s the difference between these two, and how do you know which option is best for you? Let’s dive into the details to help you make an informed decision.

What Is a Cash-Out Refinance?

A cash-out refinance is a mortgage loan that allows you to replace your current mortgage with a new, larger one and receive the difference in cash. Ideally, your new mortgage has a lower interest rate and monthly payments. You could opt for a shorter term to pay off your home sooner or a longer one to lower your payments (although you’ll generally pay more interest over time).

The process of applying for a cash-out refinance is similar to when you initially took out your current mortgage. Your lender will consider your creditworthiness, debt-to-income ratio (DTI), equity, employment, and other factors to determine if you qualify. You’ll repay the amount you borrow with a fixed or variable interest rate over a 15- or 30-year term.

Generally, lenders allow you to borrow up to 80% of your home’s value in a cash-out refinance. For example, if your home is appraised at $400,000, 80% comes to $320,000. If your current mortgage balance is $260,000, you may be able to get a cash-out refi for $320,000 and receive the $60,000 difference in cash.

Pros and Cons of Cash-Out Refinance

Pros:

• Receive a portion of the property’s value as cash.
• Lower interest rates than other credit options, often including home equity loans.
• New mortgage and cash-out amount are repaid as one loan.
• Mortgage interest may be tax-deductible if used for home improvements.

Cons:

• Closing costs of 2% to 6% of the loan amount.
• Larger loan amount could raise your monthly payments, even if you secure a lower interest rate.
• Using a loan to consolidate debt could leave you in a worse position if you rack up new balances on credit cards.
• Risk of foreclosure if you’re unable to make payments.

What Is a Home Equity Loan?

Unlike a cash-out refinance, a home equity loan doesn’t replace your current mortgage. A home equity loan is a second mortgage you’ll repay with another monthly payment.

With a home equity loan, you receive funds as a single lump-sum payment, which you must repay over a fixed term ranging from five to 30 years. These installment loans usually come with fixed interest rates, so your payment will remain the same throughout your term. As with a cash-out refinance, you can use the cash for nearly any purpose.

You may be able to deduct the mortgage interest if you use the funds to buy, build, or substantially improve your home. However, those savings could be offset by closing costs between 2% and 5% of the loan amount, although some lenders don’t charge closing costs.

Home equity loans allow you to borrow up to 80% to 90% of your home’s value based on the combined loan-to-value ratio (CLTV), which takes the balance of your first mortgage and the home equity loan into account.

Pros and Cons of Home Equity Loan

Pros:

• Lower interest rates than other forms of credit since the loan is secured by the home.
• Fixed interest rates could save money over the repayment term.
• Mortgage interest may be tax-deductible if used for home improvements.

Cons:

• Two mortgage payments could make it difficult to keep up on other bills.
• Risk of foreclosure if you miss payments.
• Closing costs, including origination fees, on your home equity loan can range from 2% to 5% of the loan amount.

Cash-Out Refinance vs. Home Equity Loan: A Comparison

Here’s a breakdown of how much you might expect to pay on a $100,000 refinance over 10 years at average interest rates versus a similar home equity loan.

In this example, the cash-out refinance saves more in interest costs. One reason cash-out refinances often have lower interest rates than home equity loans is because they assume the primary lien position, while home equity loans are second mortgages. In other words, if you fall behind on payments on a home equity loan, the home equity lender will only get paid after the primary mortgage holder is paid in full.

However, the higher interest rate on a home equity loan may be somewhat offset if you’re charged low or no closing costs. Always read the fine print on your loan to understand your potential costs. For instance, some lenders will cover the closing costs but then require you to repay some of the money if you pay off your home equity loan early.

When to Use a Cash-Out Refinance

Deciding whether to use a cash-out refinance depends on your unique financial situation. This option may make sense in certain scenarios, such as when:

• The interest rate on a refinance loan is lower than your existing mortgage, and you need extra funds.
• You want to accelerate the time to pay off your home with a shorter repayment term.
• You want extra cash at a lower interest rate to cover unexpected medical bills, pay educational expenses, or consolidate high-interest debt.
• You want a tax break on mortgage interest if you plan on using the funds to renovate your home.

When to Use a Home Equity Loan

A home equity loan is a popular option for borrowers looking to access cash at a fixed rate. You might consider utilizing a home equity loan in the following situations:

• When you want extra funds to reach a financial goal but don’t want to refinance your existing mortgage, especially if your current mortgage rate is lower than existing refinance rates.
• When you want to consolidate multiple high-interest debt accounts into a single, lower-interest payment.
• When you’re facing a large unexpected expense or short-term financial need and don’t want to pay the higher closing costs of a refinance loan—some home equity lenders may even waive closing costs.
• When you plan to use the funds to buy, build, or substantially improve your home and wish to deduct the mortgage interest.

Frequently Asked Questions

Alternatives to Cash-Out Refis and Home Equity Loans

If neither a cash-out refinance nor a home equity loan seems like the right fit, there are other options to consider, such as a home equity line of credit (HELOC) or a personal loan. Each has its own set of pros and cons, so it’s essential to evaluate your financial situation and goals carefully.

Can You Refinance a Home Equity Loan?

Yes, you can refinance a home equity loan, but it will depend on your lender’s terms and your financial situation. Refinancing could help you secure a lower interest rate or better repayment terms.

Do You Lose Equity When You Refinance?

When you refinance, you are essentially resetting your mortgage, which can affect your equity. However, if you are refinancing to a lower interest rate or shorter term, you could build equity faster.

Conclusion

Both cash-out refinances and home equity loans offer valuable ways to access the equity in your home, but the best choice depends on your financial situation and goals. If you’re looking for expert advice and personalized mortgage solutions, O1ne Mortgage is here to help. Call us at 213-732-3074 to discuss your options and find the best solution for your needs. Our team of experienced loan officers is dedicated to helping you achieve your financial goals with the right mortgage product. Don’t wait—unlock the potential of your home equity today with O1ne Mortgage!