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Cash-out refinance or home equity loan: Which should you choose?
As a homeowner, you may wonder how to tap into your house’s equity to pay off high-interest debt, finish home renovations, or cover another large expense. Fortunately, you have several options to leverage your property’s value.
Two popular home equity products include a cash-out refinance and a home equity loan. We’ll compare the two types of mortgage loans so you can choose the best one for your specific situation.
Learn more: Mortgage refinance — How to get started
In this article:
What is home equity?
Before we dive into the nitty-gritty of how these tools work, let’s define home equity. Put simply, your home equity is the appraised value of your property minus your outstanding mortgage balance.
For example, if your house appraises for $500,000 and you owe $300,000 on your home loan, you have $200,000 worth of equity, or 40%. Generally, you need 15% to 20% equity to qualify for a home equity product, though exceptions exist.
As you explore cash-out refinances and home equity loans, you might also see the term loan-to-value ratio, or LTV ratio. Your LTV ratio is another measure of how much you owe on your property compared to how much it is worth, and it’s the inverse of your home equity percentage. Continuing the example above, your LTV ratio is 60%, indicating that you owe 60% of your home’s value.
If you plan to take out a home equity loan (sometimes called a second mortgage), you should also be familiar with the term combined loan-to-value (CLTV). Your CLTV compares your total housing debt (your primary mortgage plus your pending home equity loan) to the property’s value. Typically, you’ll need a CLTV that’s 85% or lower to qualify.
What is a cash-out refinance, and how does it work?
A cash-out refinance is a type of mortgage refinance that involves taking out a large enough home loan to pay off your existing mortgage and receive a lump sum after closing. Your new mortgage may have different terms (such as your interest rate or term length) than your original loan.
Generally, you can borrow up to 80% of your home’s equity with a cash-out refinance. However, if you have a VA mortgage, you might be able to borrow up to 100%.
Your cash-out refinance may have a fixed or adjustable interest rate. If you purchased your home several years ago, your new mortgage may have a higher interest rate, as borrowing costs have soared post-pandemic.
Like your initial mortgage, you must obtain a property appraisal and pay closing costs. Once the transaction is complete, you’ll have a new mortgage loan and can use the cash however you want.
Pros of cash-out refinancing
Access the cash you need for other expenses
Receive funds in a lump sum
By refinancing instead of taking on a second mortgage, you only have one housing debt
Mortgage interest may be tax deductible if you use the money for home improvements
Cons of cash-out refinancing
Potentially higher interest rate than original mortgage
Risk of foreclosure if you default on payments
Have to pay closing costs
Reduced equity
Read more:
What is a home equity loan, and how does it work?
A home equity loan is a second mortgage you take out to tap into the equity you’ve built. Like a cash-out refinance, you can generally borrow up to 80% of your equity, and you’ll receive a lump sum after closing.
Home equity loans usually have a fixed interest rate, which means your monthly payment should stay the same over the life of the debt. Typically, your second mortgage will have a higher interest rate than your existing home loan due to the lender’s added risk (your primary mortgage holder will get paid first in the event of foreclosure). However, your closing costs may be lower than they were with your initial mortgage.
You’ll have to repay your new loan concurrently with your primary mortgage, which may be difficult to juggle. Home equity loan terms may range from five to 30 years.
Pros of home equity loans
Access the cash you need
Receive funds in a lump sum
Fixed interest rate and stable monthly payments
No impact on your existing home loan interest rate or payments
Mortgage interest may be tax-deductible
Cons of home equity loans
Risk of foreclosure if you default
Potentially higher interest rate than primary mortgage
Two housing debts to juggle
Have to pay closing costs
Reduced equity
Dig deeper: Fixed vs. adjustable mortgage rates
Comparing cash-out refinances and home equity loans
As you can see, the two options have many similarities. The biggest difference is that a cash-out refinance results in one new home loan, whereas a home equity loan results in a second mortgage. Plus, while a home equity loan is usually a fixed-rate mortgage product, a cash-out refinance may come with an adjustable interest rate, resulting in less predictable monthly payments.
Cash-out refinance vs. home equity loan: Which option is right for you?
The right home equity product for you depends on your preferences and circumstances. A cash-out refinance may work for you if you can secure a lower interest rate (or live with a higher one).
You may also gravitate toward refinancing if you only want to deal with one home loan. “By consolidating the existing mortgage and the cash-out into a single new mortgage, it can simplify [your] financial obligations and lower expenses over the short or long term,” said Stephanie Amedee, branch manager of Semper Home Loans Inc., via email.
On the other hand, Amedee pointed out that a home equity loan may be better if you already have a low interest rate on your current mortgage. Rather than getting a brand-new mortgage with a higher interest rate, you can borrow a smaller amount with a home equity loan, and the higher rate will only apply to that second mortgage balance.
Dig deeper: 4 types of home renovation loans and how to choose
Cash-out refinance vs. home equity loans FAQs
What are the different types of home equity loans?
You have two home equity lending options: the traditional home equity loan and the home equity line of credit (HELOC). The HELOC is also considered a second mortgage, but it differs from the traditional version in that you receive access to a line of credit rather than a lump sum — that’s why it’s referred to as a line of credit rather than a loan. HELOCs also tend to have a variable interest rate.
Should you tap your equity?
Tapping your home equity may be a good idea if you can use the proceeds to pay off higher-interest debt or finance a considerable expense without turning to a credit card. However, borrowing against your equity can be risky. If you default on your home equity product, you could lose your residence to foreclosure.
Is a cash-out refinance better than a home equity loan?
A cash-out refinance may be better than a home equity loan if you want to maintain a single monthly mortgage payment or can secure a significantly lower interest rate. Conversely, a home equity loan may be better than a cash-out refinance if interest rates have risen sharply since you took out your first mortgage (because the higher rate will only apply to your second home loan rather than to your entire mortgage) and you don’t mind repaying two housing debts simultaneously.
This article was edited by Laura Grace Tarpley.