When considering either a cash-out refinance or a home equity loan, homeowners may notice that the two types of loan have many similarities. Both give homeowners the ability to access the equity they have in their homes in order to complete a home renovation project or pay down some high-interest credit card debt. However, they also differ in some key ways. So what is a cash-out refinance? A cash-out refinance takes the existing loan on the home and replaces it with a new mortgage, sometimes with a shorter loan term or a different interest rate. When refinancing, homeowners have the option to take some of that equity in a lump-sum cash payment. In contrast, the best home equity loans equate to a second mortgage that the homeowner takes out on the home’s equity, paying it back with interest as a separate payment from the mortgage. Learn more about the differences between the two below to help determine which option is the right one for you.
1. Home equity loans and cash-out refinances both provide homeowners with a lump sum of cash taken from the equity they have in their home.
The major similarity between the two options is that they both allow the homeowner to access the equity they have built up in their home, either through regular mortgage payments or from an increase in their home’s value. Homeowners who have at least 20 percent equity built up in their home can generally access that amount through a cash-out refinance or a home equity loan and use the money to pay for whatever they need.
As with other types of loan, a home equity loan comes with a fixed interest rate, meaning the homeowner will pay interest on two different loans (the original mortgage and the home equity loan). So what is a refinance and how does it differ? The cash-out refinancing option takes the original mortgage and replaces it with a new one that likely has a different interest rate. The borrower then pays back the total amount of the refinanced loan (the principal) as well as interest and any closing costs.
2. A cash-out refinance replaces an existing mortgage with a new one, whereas a home equity loan is a second loan with a separate monthly payment.
What is cash-out refinance, and how does cash-out refinance work? As explained above, a cash-out refi replaces the existing mortgage with a new one. How does a cash-out refinance work? Lenders use the new mortgage to pay off the old mortgage, and then the homeowner simply ends up making payments on the new mortgage. As part of this transaction, the homeowner gets a check at closing based on how much equity they have in the home. The amount borrowed is rolled into a new mortgage, and the homeowner pays back that amount over the term of the new mortgage.
A home equity loan is a bit simpler. The homeowner borrows against the equity in the home through the lender and pays it back in monthly installments, along with interest and any fees associated with the loan. So the homeowner would end up making payments on their original mortgage each month and have a second monthly payment for the home equity loan. This is why a home equity loan is sometimes called a second mortgage. This loan type also uses the home as collateral, meaning the lender can foreclose on the home if the homeowner does not keep up with their home equity loan payments.
3. It may be easier to qualify for a cash-out refinance than for a home equity loan.
Lenders typically prefer homeowners to refinance their mortgage rather than taking out a home equity loan. If the homeowner refinances through a new lender, that gives the new lender the added business. As such, lenders may make it easier for homeowners to access refinance options so that homeowners are less likely to take their business elsewhere. Therefore, homeowners might see incentives such as more negotiable fees. Furthermore, if homeowners have proven they are able to pay on a mortgage over the long term, they pose a lower risk to the lender, who may offer refinancing more willingly.
4. The interest rate on a cash-out refinance is typically lower than the interest rate for a home equity loan.
A huge benefit to a cash-out refinance is that the interest rates tend to be much lower than the interest rates on a home equity loan. This is because a refinance is considered a first loan, which means the proceeds from selling or foreclosing on the home will go to pay off that loan before they would pay off the second mortgage, or home equity loan. That makes a home equity loan more risky for the lender, since it will not be the priority loan to pay off if the homeowner defaults on their mortgage or is forced to sell the home at a loss. In this case, the home equity loan lender may lose its money, or at least a good portion of it. Therefore, a higher interest rate on this type of loan helps make it a better deal for the lender. In contrast, a cash-out refinance may result in a lower interest rate than the homeowner has been paying on their mortgage, depending on the going interest rate.
5. Closing costs and fees for a home equity loan are generally lower than for a cash-out refinance.
Another point worth considering is the closing costs and fees. These can range in the thousands for a refinance with cash out, but they are generally much lower for a home equity loan. This is because the homeowner is not setting up a brand-new mortgage, so many of the fees associated with creating a new mortgage simply aren’t there. Some financial institutions even advertise no closing costs on setting up a home equity loan, so it’s a good idea to shop around to see what lenders are offering.
6. A home equity loan may enable the homeowner to borrow more of their home’s equity without the requirement for mortgage insurance.
One point homeowners might not be aware of is that setting up a brand-new mortgage as part of a cash-out refinance could introduce the requirement of mortgage insurance. Mortgage insurance protects the lender in case the borrower defaults on the mortgage and may be required for a homeowner to pay in certain circumstances. For instance, homeowners who have less than 20 percent in equity are generally required to pay mortgage insurance to the lender until they reach that equity level, at which point they can cancel the mortgage insurance. Also, mortgage insurance is required for certain types of government-guaranteed loans, like FHA or USDA loans. A home equity loan bypasses the need to worry about mortgage insurance because it is separate from the main mortgage on the home.
7. A home equity loan is typically a better option for homeowners who don’t want to refinance or who plan to move in the near future.
There are many valid reasons a homeowner may not want to refinance their mortgage. For example, if interest rates have risen recently, it likely doesn’t make sense to refinance to a loan with a higher interest rate. The homeowner might also not be comfortable adjusting the terms of their current mortgage, since it could affect the length of time it takes to pay off the house or increase their monthly mortgage payments.
Anyone who plans to move in the near future might also not want a refinance cash-out option since they will be leaving the home and getting a new mortgage soon. Such a homeowner would incur new closing costs and other fees, and then not stay in their current home long enough to recoup the losses of paying those costs.
Homeowners might also want to look into a cash-out refinance vs. HELOC (home equity line of credit), which is another option for homeowners to tap into their home’s equity.
8. A cash-out refinance is typically a better option for homeowners who want to lock in a lower interest rate on their mortgage while tapping into their equity.
A cash-out refinance can be a good solution if refinancing means a lower interest rate than the homeowner is currently paying. For instance, interest rates could be lower than when they first bought their home, or they may have improved their credit score and now qualify for better rates. That low interest rate then stays the same through the length of the new mortgage if the homeowner chooses a fixed-rate option. The cash-out payment could help consolidate debt, go toward a new home addition, pay for education, or whatever the homeowner needs the money for. Meanwhile, the homeowner can also enjoy a similar or lower monthly mortgage payment by refinancing at a lower interest rate.