If you’ve owned your home for a while, you likely have thousands of dollars in equity, which is the difference between the current market value of your home and what you owe on it.
The advantage of having equity is that you can borrow against it, which is especially handy if you want to make major home improvements, have high-interest debts to consolidate, or need money for education expenses or unexpected medical bills.
When deciding the best way to access their equity, homeowners have to consider the benefits of a cash-out refinance vs. home equity loan. There are similarities between the two, but also some important differences.
Knowing how each one works can help you choose the right one for your financial needs:
- What Is a Cash-Out Refinance?
- What Is a Home Equity Loan?
- Differences Between a Cash-Out Refinance and a Home Equity Loan
- Is a Cash-Out Refinance Better Than a Home Equity Loan?
- Do You Have To Pay Taxes on a Cash-Out Refinance?
- The Bottom Line on a Cash-Out Refinance vs. Home Equity Loan
A cash-out refinance involves taking out a new mortgage based on the current value of your home, using that money to pay off your original loan — and pocketing the difference. You then repay the borrowed cash as part of your new mortgage.
Most people use the money to pay major expenses that have long-term benefits — such as home improvements, education costs, and eliminating high-interest debt — or large, unexpected expenses such as medical bills.
While this can raise your monthly mortgage payment, interest rates on a refinance are typically lower than for other common types of credit, such as personal loans or credit cards. That makes a cash-out refinance an attractive way for homeowners to borrow money cheaply.
Here are some of the key benefits of a cash-out refinance:
- It may simplify your finances. If you have a lot of debts to pay each month, borrowing against your home equity and consolidating your debts can reduce the number of bills you have to worry about.
- It could save you money on interest. Because your mortgage is backed by the value of your home, cash-out refinances generally offer lower interest rates than other types of loans. Consolidating debts could reduce the overall interest you pay on your financial obligations.
- You could add value to your home. One use of a cash-out refinance is to renovate or make improvements to your home that can increase its value in the long term.
While a cash-out refinance makes sense in many instances, there are some drawbacks:
- It could take longer to repay your mortgage. If your new mortgage has the same term as your original loan, you’ll have to restart the repayment schedule. This means you will make payments for a longer period before you finish repaying the loan.
- You need to pay additional interest and fees. Since your new loan likely will have a higher balance, you could end up paying more interest overall than you would by keeping your current loan. You also have to pay closing costs on the refinance, which may take you a while to recoup.
- You risk foreclosure. As with all loans backed by your home, the bank may foreclose on your property if you fail to make payments.
A cash-out refinance makes the most sense when you use the money to meet a long-term financial goal. Common reasons include paying for home improvements that increase the value of your home, getting a college education, or consolidating debts to save money on interest.
Here’s an example: Let’s say that you bought a house for $200,000 and took out a $160,000 mortgage. After a few years, you’ve paid down your mortgage balance to $150,000, and your home now appraises for $300,000.
You could borrow 80% of the home’s value, which would be $240,000. After paying off the $150,000 on your existing mortgage, you’d close with a check for $90,000. If you use that money to improve your home and its value increases to $400,000, then your cash-out refinance would have helped increase your overall wealth.
Also known as a second mortgage, a home equity loan is a new loan that you take out in addition to your current mortgage, which you’ll continue to pay.
A home equity loan is more like a regular loan, where you borrow a lump sum and then repay it according to the terms of the loan. Home equity loans have terms from five to 30 years, and usually feature a fixed interest rate and a stable monthly payment.
Your home is the collateral for the home equity loan, which means home equity loans usually offer lower interest rates than personal loans or credit cards.
Both a home equity loan and a cash-out refinance loan are conventional loans, like a student loan or auto loan. This means you will have to pay closing costs — like loan origination fees, appraisal fees, or recording fees — to get the loan.
These are some of the main benefits of getting a home equity loan:
- Possible tax deduction. If you use a home equity loan to make improvements to your primary residence, you might be able to deduct the loan interest on your taxes.
- Lower interest rates than some options. Because your property is collateral for the home equity loan, you’ll usually get a lower interest rate than with a personal loan or credit card.
- Fixed interest rate and payment. Unlike a home equity line of credit — commonly known as a HELOC — a home equity loan has a fixed interest rate and payment for the term of the loan. That means you know exactly how much your payment will be each month, and when the loan will be paid off.
- Higher loan-to-value ratio. Some lenders will let you borrow as much as 100% of your home’s appraised value, though 85% is the more common limit. This could get you access to more cash if you need it.
Check out the drawbacks to a home equity loan before choosing this option:
- Higher interest rates than a primary mortgage. While interest rates on home equity loans are lower than those for personal loans or credit cards, they are higher than rates on first mortgages. This is because the home equity loan is in a secondary position behind your original mortgage, meaning it is second in line for repayment in the event of a default.
- Additional payments. You’ll have two mortgage payments to keep track of and make each month.
- Your home is at risk of foreclosure. Just as with a cash-out refinance, your home equity loan is backed by your property. If you can’t afford the payments and end up defaulting on the loan, you may lose your home.
When looking at a home equity loan vs. refinance, there are certain situations where a home equity loan can make sense. A home equity loan could be better for homeowners looking to borrow a larger portion of their equity, or who wish to repay the amount they borrow more quickly than their primary mortgage.
For example: Say your home is worth $400,000 and you have a mortgage for $250,000. If a lender is willing to lend up to 85% of your home’s appraised value, you could get a home equity loan for $90,000 with a 10-year term.
You’ll keep your existing $250,000 mortgage and continue paying it. You’ll also make fixed payments on your home equity loan for the next 10 years, on top of your regular monthly mortgage payment. After those 10 years, the home equity loan will be repaid — without extending or altering the terms of your first mortgage.
When comparing a home equity loan vs. cash-out refinance, there are a couple of differences that you’ll want to be aware of.
One disadvantage of a cash-out refinance is that you’re restarting a 30-year mortgage unless you choose a shorter loan term, according to Kelly Moran, a licensed mortgage loan originator with Forcht Bank in Cincinnati.
With a home equity loan, you keep your existing mortgage. That could make a difference in how long it takes you to finish repaying your mortgage.
Another difference between a cash-out refinance and a home equity loan is the amount of equity that you can access. Usually a cash-out refinance is limited to 80% of your property’s value, while a home equity loan may allow you to access 85% or more of your home’s equity.
Whether a cash-out refinance or a home equity loan is better depends on your financial situation and goals.
A cash-out refinance can spread out the cost of repaying your loan over a longer period, which could make it more affordable. A refinance is also streamlined — you repay it as part of your mortgage instead of making a separate loan payment.
“A cash-out refinance is an exceptional way to do not only home improvements but consolidate high-interest debt and just increase your mortgage payment by only a few hundred dollars,” says Jonathan Thomas, a licensed mortgage loan originator based in Charlotte, North Carolina. “It’s incredible because you can get a low fixed interest rate.”
But a home equity loan could keep you on track to fully owning your home without extending your mortgage term and potentially paying more interest. It also lets you predictably pay off the amount you borrow, so you know how much you have to pay and when you’re done.
If you’re getting tens of thousands of dollars — or more — from a cash-out refinance, you might wonder if you’ll have to pay taxes on it. The good news is that the proceeds from a cash-out refinance are considered a loan instead of income, so you don’t have to pay taxes on the money you borrow.
Building equity is one of the biggest advantages of owning a home. Deciding between cash-out refinancing vs. a home equity loan is a major decision for homeowners looking to access their equity. Knowing the ins and outs of each lets you decide which option is right for achieving your financial goals.