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.
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 loan 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.
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. 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 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.
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 2020, 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 2023, the 30-year rates are in the 6.5% 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.
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 Home Equity 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.
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.
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 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.org
Bryan Dornan is a financial journalist and currently serves as Chief Editor of RefiGuide.org. Bryan has worked as a mortgage loan officer in the industry for over 20 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, Linkedin and ActiveRain.
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