Each loan type allows homeowners to borrow against their home’s equity by using the home as collateral. While the purposes of each are similar, the processes are different.
What's in this article?
A home equity loan or home equity line of credit (HELOC) is a second mortgage you take out in addition to your original mortgage. A cash-out refinance replaces your current mortgage with a new one.
Let’s take a look at the differences between a cash-out refinance and a home equity loan, as well as the pros, cons and costs of each type.
What is the contrast between a cash-out refinance and a home equity loan?
A cash-out refinance loan and home equity loan both have benefits and drawbacks depending on the unique needs of a homeowner.
While both loans allow homeowners to tap into the home’s value, they approach this goal in different ways.
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What is a cash-out refinance?
When a homeowner refinances, they replace their existing loan with a new one that has a different interest rate (fixed or adjustable) and duration.
A cash-out refinance is a type of refinancing that also allows the borrower to tap into their home equity.
Your home equity increases over time as you make your monthly mortgage payments and as the home naturally appreciates.
If you choose a cash-out refinance to tap into this equity, you replace your original mortgage with a new loan that’s larger than what you currently owe. The difference between the two loan amounts is paid to you in cash, which you can use however you choose.
A cash-out refinance will result in a new mortgage interest rate and terms (length or duration); so if your current rate is low, you may not want to change it.
Let’s take a look at the pros and cons of a cash-out refinance.
Cash-out refinance pros
- Access to a significant amount of cash, depending on how much equity you have in your home
- Lower interest rates than a personal loan or credit card because your home secures the loan
- If you use the cash-out for home improvements, you may get a tax break
- Loan terms usually are 15 or 30 years, so you have plenty of time to repay the loan
Cash-out refinance Cons
- You’ll have to pay closing costs and fees to close on your loan
- Your home is used as collateral; so if you can’t make your payments, you risk losing your home
- You may be adding to your lifetime interest costs by restarting your mortgage term
Costs and requirements
Closing costs and fees for a cash-out refinance usually are anywhere from 3% to 5% of the loan amount.
The fees are similar to what you paid for your original loan, including an origination fee and a possible appraisal.
To qualify for a cash-out refinance or home equity loan, borrowers generally must have at least 15% to 20% equity in their homes.
You also will have to meet certain lender requirements such as credit score, debt-to-income ratio (DTI), income verification and proof of employment.
You can use the funds from a cash-out refinance in whatever ways you choose. The most common uses for home equity include home improvements, debt consolidation, college tuition or emergency funds.
What is a home equity loan?
One of the greatest benefits of a home equity loan or HELOC is that your original mortgage remains untouched. You will borrow the funds you need and make payments in addition to your regular monthly mortgage payments.
The difference between a home equity loan and a HELOC is how the funds are distributed. A home equity loan provides the funds as a lump sum that is repaid at a fixed rate, while a HELOC usually has adjustable rates and functions similarly to a credit card.
The decision between a home equity loan or cash-out refinance ultimately depends on the homeowner’s goals and how they plan to use the funds.
A cash-out refinance can be more helpful if the borrower wants to obtain a lower interest rate or change their terms. A home equity loan may be best if the borrower knows the exact amount they need, and they don’t want to change their original mortgage interest rate or terms.
Here are the pros and cons of home equity loans.
Pros of a home equity loan
- Lower interest rates than credit cards or personal loans
- Lower closing costs than a cash-out refinance, since you aren’t replacing your original mortgage
- You can receive the money as a fixed-rate lump sum (home equity loan) or draw funds as needed (HELOC), and use the money however you choose
Cons of a home equity loan
- Interest rates are slightly higher for home equity loans and HELOCs than a cash-out loan
- Your home is being used as collateral, so there’s a risk of losing your home if you can’t make your payments
- Can be a bit more difficult to qualify for than a cash-out refinance
Costs and requirements for a home equity loan
Closing costs for home equity loans generally run from 2% to 5%, although some lenders offer low or no closing costs.
Lenders can be a bit more strict with home equity loan requirements because they are second mortgages—and second in line to be repaid after the first (primary) mortgage.
Similar to cash-out loans, home equity loans and HELOCs also require at least 15% to 20% equity in your home. You will have to meet specific lender requirements based on your credit, DTI and income.
Is a cash-out refi easier to get than a home equity loan?
Qualifying for a cash-out refinance can generally be a bit easier than qualifying for a home equity loan because, again, of the home equity loan’s position in second place.
However, lenders today have worked hard to mitigate these risks by putting specific requirements in place to protect both borrowers and lenders.
The decision between a cash-out refinance and a home equity loan is personal because it depends on a borrower’s unique goals and financial situation.
For example, if you want to lower your rate, adjust your terms and pull from your equity in one move, a cash-out refinance may be best.
If you want to leave your original mortgage alone, you have a strong credit score and you know exactly how you want to use the funds from your equity, a home equity loan or HELOC could be a better option.
How to apply for a home equity loan or cash-out refinance
If you’ve decided you want to tap into your home equity and are ready to take the next steps, connect with an experienced loan officer at Compass Mortgage today.
With Compass Mortgage, you can expect a more personal, more human lending experience.
We promise to be your advocate and partner through every step and to help you find the most affordable way to tap into your home equity.
Photo by Karolina Grabowska