Your home is more than just a place to hang your hat — it's a cornerstone of your life and a significant investment. It might be the most valuable investment you'll ever make. As the years pass, your home has likely appreciated, building equity that can unlock financial opportunities. Maybe you're dreaming of a renovation, paying off high-interest debt, or funding your child's education — tapping into your home's equity can help bring those dreams to life.
Two common loan options are a cash-out refinance and a home equity loan. They're both ways to tap into your home's equity and use your home as collateral to back the loan. In this guide, we'll shine a light on the difference between a cash-out refinance versus a home equity loan, the pluses and minuses of each, and how to gauge which is the best option for you.
What is a cash-out refinance?
A cash-out refinance replaces your existing mortgage with a larger one and lets you pocket the difference. The loan is based on the amount of equity you own and how much a lender will allow you to borrow — typically up to 80% of your home value. Homeowners can use the funds for any reason, such as debt relief, home renovations, or even to invest in a second property.
How does a cash-out refinance work?
Let's say you have a mortgage balance of $300,000 on your home, which is valued at $500,000. You can apply for a new mortgage of $400,000 — $100,000 more than your existing balance. After the refinance, you'll receive the $100,000 as a lump sum payment.
Cash-out refinancing can come with either fixed rates or variable interest rates. The interest rate you receive is tied to the 10-year Treasury bond. The interest rate also depends on your credit score and other financial factors, such as your income and debt-to-income ratio.
Pros and cons of a cash-out refinance
Let's look at some advantages and downsides of a cash-out refinancing loan:
Steady payments. Cash-out refinances can come with either fixed or variable interest rates. However, they usually feature fixed rates. If your cash-out refinance is a fixed-rate mortgage, you'll be able to predict your monthly payments and budget for years to come.
Tax deductible. If you use the money from your cash-out refinance for home improvement projects that can boost your abode's value, you could enjoy a tax break. As long as the money is used toward a home renovation, you can most likely deduct the interest paid on the mortgage come tax time.
Lower borrowing rates. Cash-out refinancing typically has lower interest rates than other types of financing, such as credit cards and personal loans.
Potentially increased interest rate. There's a chance your mortgage rate could go up, which means the mortgage costs you more. It's typically a good idea to do a cash-out refi if you can land a lower interest rate. Otherwise, your mortgage will be more expensive.
PMI payments. While you usually can withdraw up to 80% of your home equity, some lenders let you withdraw up to 90% of your home equity. In this case, you might be on the hook for paying private mortgage insurance (PMI).
Closing costs. Just like when you had to pay for closing costs when you took out your mortgage, you'll be responsible for closing costs on a cash-out refinance. Typical closing costs might include:
- Loan origination fee
- Appraisal fee
- Attorney fee
- Application fee
- Credit report fee
- Document and filing fees
- "Points" to lower the interest rate
Expect to pay around 2% to 6% percent of the loan amount for closing fees.
Home equity loan
What is a home equity loan?
A home equity loan, or second mortgage, is when you borrow against the equity in your home for a lump sum of cash. Homeowners typically need 15%-20% of equity to qualify. The funds can be used for any purpose, such as home renovations or debt consolidation.
How does a home equity loan work?
A home equity loan is a type of installment home loan. You're responsible for making monthly payments that are the same amount. This payment includes the principal amount plus interest fees.
The interest rate you get approved for depends on the market environment, lender, and financial factors such as your credit score, income, and debt-to-income ratio. The life of the loan can vary, and can be anywhere from 5 to 30 years.
Pros and cons of a home equity loan
Here are some advantages and disadvantages of a home equity loan:
Lower borrowing rates. Compared to personal loans and credit cards, a home equity loan typically features lower interest rates.
Fixed monthly payments. A home equity loan features monthly payments that don't change over the course of the loan. This makes it easier for you to budget.
Tax deductible. You might be able to deduct the interest you pay on your home equity loan from your taxable income.
Risk borrowing too much. You get a single lump sum, and there's a chance that you're borrowing either too much – or too little. In the first case, borrowing too much means, you're paying unnecessary interest.
Closing costs. Common closing costs that come tacked onto your home equity loan are usually lower than that of a typical mortgage and can be anywhere from 2% to 5% of the loan amount.
Two mortgage payments. You essentially will be responsible for two mortgage payments – the mortgage on your current home and your home equity loan. Expect to make payments for decades to come.
Cash-out refinance vs. home equity loan: what to consider
These financial tools allow you to tap into the equity you've built in your home, but they have distinct features that may make one a better choice for your situation.
Interest rates: Currently, the interest rates are hovering at 6.53% for a 15-year fixed and nearly 7% for a 30-year fixed refinance. The range for a 15–year fixed home equity loan is anywhere from 6.72% to 10.43%.
If the interest rate on your new mortgage for a cash-out refinance, you'll be paying more interest fees. In turn, it might not be the best route to take. The higher the interest rate on a home equity loan, the more expensive it is.
LTV: Cash-out refinance typically allows you to access a higher LTV ratio, often up to 80% or even 90% of your home's value. On the other hand, home equity loans may offer a lower LTV ratio, often ranging from 75% to 85%. Evaluating how much equity you currently have in your home and how much you need to borrow will help you decide which option aligns better with your financial goals.
Fees and closing costs: Cash-out refinancing usually involves paying closing costs, including appraisal fees, origination fees, and other charges. Home equity loans have lower upfront costs, making them more cost-effective if you require a smaller loan amount.
Risk: Both products are backed by the equity in your home, meaning your home is collateral. Should you default on payments, lenders can foreclose on your home.
Repayment: The most common repayment term for both options is 30 years. However, the typical repayment terms for a cash-out refinance is 15 to 30 years, while the repayment term for a home equity loan is anywhere from 5 to 30 years.
The longer the term, the more you'll be paying interest fees over the loan.
Credit score and debt-to-income ratio: Your credit score and debt-to-income ratio impact the rates and terms you qualify for. Lenders have different lending criteria, but generally, your DTI can't be more than 43% for a home equity loan or cash-out refinance. The minimum credit score also can vary, but a minimum credit score of 620 is usually required for a cash-out refinance and 680 for a home equity loan.
Your long-term financial goals: If you aim to pay off your mortgage sooner, a cash-out refinance might not be the best choice, as it will reset the clock on your mortgage term. However, if you're comfortable extending the repayment period and want to access a significant sum, a cash-out refinance could be a viable option. On the other hand, if you prefer to keep your existing mortgage intact and want a separate loan for a specific purpose, a home equity loan can provide the necessary funds without affecting your primary mortgage.
Figuring out the best way to tap into the equity you've built into your home for cash is no light decision. The best choice for you depends on a mix of external factors—such as the current economic environment and market rates— and internal factors, such as your financial picture, credit score, and your current situation, needs, and lifestyle preferences.
If you're looking for an option that won't lock you into payments for decades to come, consider a home equity investment (HEI). An HEI from Point can be the best choice for you. With an HEI, you can get cash to fund your goals and projects — without worrying about a 30-year repayment. Point can help you lock in the funds needed to enjoy your beloved home and good quality of life for decades. Reach out to one of Point's team members to see what you might qualify for.