Cash-Out Refinance vs. Home Equity Loan: Which Is Better?
Cash-out refinancing and home equity loans offer two different ways to get money out of your home. While similar in some ways, each route comes with features that will make them more suitable to particular kinds of borrowers. We take a closer look at the pros and cons of a cash-out refinance vs. a home equity loan
Home Equity Loan vs. Cash Out Refinance
Your home is your single biggest asset, and if you’ve owned yours for more than a year or two you probably have a reasonable amount of equity in your property. Equity is the portion of your mortgage balance you have already paid off.
Your equity is also a growing source of long-term security as your home’s value increases, but sometimes you need to turn that wealth into actual cash you can use to pay for more urgent necessities like a much-needed home upgrade or college tuition—or just to get a handle on your higher-interest debt.
Cash-out refinancing and home equity loans offer two ways to tap into your hard-earned equity. Let’s look at how these popular products work, their important differences, and the benefits and drawbacks of each so that you can determine which would be best for you.
What Is a Cash-Out Refinancing?
A cash-out refinancing of your home is essentially a new mortgage that replaces your existing home loan and gives a chunk of the amount you have already paid off (your equity) back to you as cash. Essentially, cash-out refinancing allows you to access the money you have already put into your home without actually selling your home.
How Does It Work?
Say you bought a home for $300,000 and the value of your home is now $400,000. After making both your down payment and your regular mortgage payments, you managed to pay down 40% of the original balance ($120,000 in payments; remaining balance of $180,000). You now have 30% equity in your home ($120,000 available on a home worth $400,000).
Refinancing lets you take this equity out as cash and repay a new mortgage calculated on the current price of your home. Most lenders will not allow you to refinance for more than 80-85% of the current market value of your home.
This is known as your loan–to–value (LTV) ratio, and provided your home has increased in value it will work in your favor when you refinance.
For example, based on an 80% LTV, you could refinance the above $400,000 home for $320,000. Assuming you still owed 70% of the original $300,000 mortgage, you could take the 30%, or $90,000, you have already paid out as cash, PLUS the $20,000 difference between the original mortgage amount and refinanced value of your mortgage — a total of $110,000.
Remember that the interest rate on your refinanced mortgage can be lower or higher than your original and the life of your loan can also change.
Pros of Cash-Out Refinancing
While refinancing a home may seem like a drastic step to take to free up cash, it has clear advantages in the right circumstances. Some of these include:
- Lower Interest Rate: Your refinanced loan is still secured by your home and that means the annual percentage rate you pay on your interest is going to be far lower than most other forms of borrowing.
- Long Repayment Terms: You’ll also be able to repay your mortgage over a longer period (up to 30 years), making it easier to spread out the cost of cashing out your equity.
- Single Payment: You’ll free up cash without taking on extra debt. You’ll still make a single fixed payment every month and the payment will be lower.
- Consolidate Debt: Low rates, fixed terms, and long-term payments make cash-out refinancing a viable way to pay off significant debt. You can exchange soaring balances and late fees for a single, fixed payment that takes care of your debt over time.
- Lower Payments: Taking into account your credit, how much equity you have built up, the new loan term you choose, and current market conditions, your monthly payments on your refinanced loan might be lower than on your original mortgage.
- Lower LTV Ratio: Depending on how much of your equity you choose to cash out, the loan-to-value ratio of your refinanced loan might be lower than your original mortgage. This will boost your credit score and help you rebuild the equity you cashed out sooner.
- Remove PMI: If you put down less than 20% on your original mortgage you more than likely had to pay private mortgage insurance (PMI) to secure your loan. A refinanced loan will usually require an equity stake of at least 20%, meaning that you should not have to pay for PMI anymore.
- Tax Savings: Interest charged on a mortgage on a primary residence is often tax deductible. Consult your tax advisor to see how tax provisions might apply to you.
Cons of Cash-Out Refinancing
At the same time, cash-out refinancing can have serious and long-term consequences for your finances. These may include:
- A Bigger Loan: If your home has increased in value and you are cashing out a significant amount of equity, then your refinanced mortgage is more than likely going to be bigger than your original loan.
- Longer to Pay Off: By cashing out your equity, you will be restarting your loan from scratch, perhaps after years of making payments. It will take you longer to own your home free and clear.
- Liquidated Equity: By cashing out equity you are removing its ability to grow along with the value of your home. It will be a long time before you can rebuild your equity position and you will not benefit as much from growth until you do. You’ll also make less money if you decide to sell your house.
- High Closing Costs: Refinances tend to include many of the same loan costs as your original mortgage including origination, processing, title search, appraisal, and other fees.
What Is a Home Equity Loan?
A home equity loan is a “second mortgage” secured against your home that allows you to borrow part of the value of the paid-off portion of your original mortgage as cash. You will then need to repay this amount over time while continuing to pay down your original home mortgage.
How Does It Work?
A home equity loan allows you to tap into the equity of your home while leaving your current mortgage in place.
To do this, most lenders will require you to demonstrate a combined ratio of 80% between the outstanding amount on your mortgage and what you will owe on your home equity loan. This is known as your combined loan-to-value (CLTV) ratio.
For example, if you still owe $210,00 on your mortgage on our $400,000 home, you could theoretically borrow up to $110,000 in a home equity loan with a CLTV ratio of 80%.
As with a refinanced loan, you would receive an interest rate, terms, and monthly payment based on your credit score, income, and other factors. However, you would be paying this second loan down simultaneously with your mortgage payments and both loans would be secured against your home.
Pros of Home Equity Loans
Home equity loans allow you to benefit from the equity you hold in your home while leaving your mortgage in place. This comes with some clear advantages, including:
- Get Cash Out While Protecting Your Low Home Loan Rate: Keep your low fixed-rate home loan while freeing up money to pay off credit cards or other high-interest debts.
- Pay Off Loans Sooner: By borrowing against your equity rather than liquidating it you will retain your original mortgage balance and continue to pay it off, meaning you will fully own your home sooner.
- Equity Exposure: The equity you retain in your home continues to grow even as you repay both your mortgage and your home equity loan, maximizing your exposure to increases in property value.
- Lower Closing Costs: Home equity loans generally have less expensive closing costs than full cash-out refinances, making it a cheaper way to access ready money or consolidate smaller debts. Some lenders, like Freedom Credit Union, even offer generous home equity loans with no closing costs.
- Home Improvements: Home equity loans are good for funding improvements, especially for the property they are secured against. Also, interest paid on loans used to fund improvement to your home or property is usually tax-deductible.
Cons of Home Equity Loans
That said, home equity loans come with some significant potential drawbacks compared with other forms of borrowing. These include:
- Higher Rates: Home equity loans are secured loans, but lenders know you are more likely to default on a home equity loan than a mortgage, therefore interest rates are still higher than for mortgages.
- More Debt: A home equity loan is another source of debt and another monthly payment you need to keep up on, often over a long time period. That’s an extra burden every month and the increased risk will affect your credit score too.
- Higher CLTV Ratio: A home equity loan might also increase the combined loan-to-value ratio on your property. This will affect your credit score and could make it harder to refinance your property in the future.
- Credit Score: A home equity loan is considered a new source of debt and you will need relatively good credit to access a home equity loan at a reasonable rate and on favorable terms.
- Increased Risk: A home equity loan or “second mortgage” is secured against your property in the same way that your original mortgage is, potentially putting your home at risk if you can’t make payments on either loan.
Key Differences
Cash-out refinancing and home equity loans each allow homeowners to turn the equity they hold in their properties into actual cash, and both do it by securing borrowing against the property itself. They also both offer fixed, long-term repayment at relatively low rates, making them a good way to spread out the cost of tapping into home equity.
They are also very different products. Most importantly, a cash-out refinance liquifies your equity by effectively selling your loan back to the bank, while a home equity loan leaves your equity in place, but allows you to borrow its value.
Cash-out refinances are also “first lien” products, which means the lender has control over the asset itself and can recover losses if the borrower defaults.
Home equity loans are usually “second lien” products, which means the lender would be second in line to recover funds in the event of a default. That can mean higher interest rates, although some lenders, like Freedom Credit Union, offer lower rates on specially secured home equity loans to qualified borrowers.
The following table summarizes some other key differences between cash-out refinancing and home equity loans:
| CASH-OUT REFINANCE | HOME EQUITY LOAN | |
|---|---|---|
| Equity | Paid as cash | Equity stays in place |
| Lien | First | Usually second |
| Interest Rate | Low | Higher |
| Loan Size | Up to 80% LTV | Up to 80% CLTV |
| LTV Change | Increases | Stays the same |
| PMI Required | Yes, for LTV above 80% | No |
| Closing Costs | High | Lower |
| Credit Score Required | Average | Good |
Which One Is Right for You?
Cash-out refinancing and home equity loans offer different-sized payouts, payment terms, and long-term effects on your equity. It’s important to consider which suits your financial needs now and into the future. It’s also important to consider the total cost of financing your loan over time.
| 30-YEAR CASH-OUT REFINANCING | 30-YEAR HOME EQUITY LOAN | |
|---|---|---|
| Loan Amount | $150,000 | $150,000 |
| Closing Costs (3%) | $4,500 | $0* |
| Interest Rate | 6.25% | 6.25% |
| Monthly Payment | $1,153 | $1,119.47 |
| Cost in first 24 months | $27,665 | $26,867 |
| Cost in first 48 months | $55,329 | $53,735 |
| Cost in first 60 months | $79,161 | $77,168 |
This example compares the costs over the first five years of a 30-year cash-out refinancing versus those of a similar-sized 30-year home equity loan.
By choosing a lender like Freedom Credit Union that offers no closing costs on home equity loans, you would save almost $2,000 within the first five years of your loan, and more as the loan continues to amortize.
In addition, the borrower with the home equity loan retains equity in their property that will grow even as they continue to repay both loans. The owner of the refinanced mortgage will most likely have to start building equity from scratch.
The advantages of each route to freeing up cash depend on your circumstances. Let’s see how these differences might play out for different types of borrowers.
When to Use a Cash-Out Refinance
Cash-out refinancing makes sense for borrowers who want to reduce their interest costs and monthly payments to make homeownership more affordable while freeing up cash for the things that are important today, including home improvements or college tuition.
You can also use cash-out refinancing to consolidate debt. Exchanging several high-interest loans for a single, low monthly payment will spread the load and allow you to rebuild your credit score. However, the relatively high upfront costs of this loan mean you should probably only consider this route if you have very significant debts to cover.
You’ll also miss out on future equity growth for a while, so this might not be the best option if you expect the value of your property to grow rapidly while you are paying off your refinanced loan.
When to Use a Home Equity Loan
A home equity loan makes sense if you are looking to make the most of your property. Tapping your equity to make improvements to the same property is a great way to supercharge your equity growth while adding upgrades to the home you live in.
While you’ll pay more interest, you’ll benefit by being able to continue to grow your equity, so this is a good choice if you expect the value of your property to increase.
The lower up-front loan costs and the ability to borrow smaller amounts can also make home equity loans a more affordable way to manage the consolidation of more modest debt amounts over longer periods. But, you will need a better credit score to qualify, and taking on extra debt will affect your debt-to-income ratio.
In short, home equity loans are cheaper to access but more expensive to finance over time. You will benefit in the long term, however, by protecting your equity stake in your property.
Hybrid Options
It is possible to get a bit of the best of both worlds when tapping your equity for cash by choosing some innovative “hybrid” loans offered by some lenders. Freedom Credit Union, for example, offers well-qualified buyers a “first lien” home equity loan at significantly lower rates than either a traditional home equity product or a conventional mortgage.
By becoming the first lien on your property, a home equity loan can gain the same access to your collateral that a refinanced mortgage would have, while still keeping your equity stake in your property so you can continue to benefit as your home’s value grows over time.
Freedom Credit Union: Set Your Equity Free
At Freedom Credit Union we help our members get more out of home ownership with smart, competitively priced cash-out refinancing and home equity loans.
Whether you’re looking to free up serious funds to help finance a second home or just want to lower your monthly payment, Freedom CU cash-out refinancing offers competitive rates and cash in your pocket to use for anything you see fit.
See Our Refinance Options & Benefits
If you’re looking to get more out of your property by putting more in, then a Freedom CU home equity loan allows you to leverage your equity while protecting its value, tapping cash you can use for home renovations, covering college costs, and more.
We offer loans of up to $250,000, low rates, and little to no closing costs. Plus we’ll let you borrow up to 110% of your home’s value, with all decisions being made locally by our knowledgeable Freedom CU staff. No matter how you look at it, it’s cash on the house!
