Cash out refinance vs. home equity loan: What to know

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. 

Whether you’re dreaming of home improvements or paying off high-interest debt, cash-out refinances and home equity loans are two popular ways to use the home equity you’ve been building up. We'll shine a light on the difference between a home equity loan vs. cash-out refinance, including 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. Typically, you can choose from 15- or 30-year loan terms. 

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.

Cash-out refinance pros

• Lower interest rates
• Choose variable or fixed rates
• Only one home loan to manage

Cash-out refinance cons

• Longer loan application process
• Refinance closing costs range from 2% to 6% of your loan balance
• Lenders may charge private mortgage insurance (PMI) if your loan exceeds 80% of your home value

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 and repay it over a five- to 30-year period. Rather than combining everything under one loan, you’ll have two separate loans: your primary mortgage, which doesn’t change, and your new home equity loan that’s also linked to your home. 

Homeowners typically need 15%-20% of equity to qualify. The funds can be used for any purpose, such as home renovations or debt consolidation.

Home equity loan pros

• Fixed interest rates
• Lower closing costs
• Quicker loan application process

Home equity loan cons

• Higher interest rates
• Must manage two home loans
• Requires two separate liens on your home: primary mortgage, and home equity loan

Cash-out refinance vs. home equity loan: Which makes sense for you?

The reality is that, for most people, both options have something to offer. It’s simply a matter of determining which factors are most important to you, and then running the numbers to ensure you’re comfortable and able to handle the change in debt payments. 

Let’s look at a few common scenarios to see when a home equity loan vs. a cash-out refinance might make more sense. 

You want a lower mortgage rate: Cash-out refinance

Cash-out refinancing generally yields a better interest rate than home equity loans in most cases. That’s because a cash-out refinance takes first-lien position, meaning that if you default on the loan, that lender will be paid first from a foreclosure sale. 

In contrast, home equity loans generally rely on a second-lien position, meaning they’ll be next in line to be repaid, if there’s anything left from the home sale. It’s a riskier stake, and for that reason, home equity lenders often charge slightly higher rates. 

Homeowners often see an increase in their credit score after they’ve been making on-time payments for a while. It’s also possible that rates have gone down across the board since you first took out your mortgage. In either case, refinancing when you already need to borrow money can help you accomplish two objectives at once: getting a better mortgage rate and accessing low-cost financing. 

You want to keep your existing mortgage in place: Home equity loan

There are also many reasons why you might want to keep your current mortgage. If you’re already paying a lower interest rate than you can otherwise qualify for in today’s market, for example, it might make more financial sense to parse out your debts using a home equity loan. 

That way, you can keep your low-interest mortgage, but still get the financing you need. Your home equity loan debt might come with a higher rate, it’s true, but it’s still generally much less than with, say, a credit card. 

You want to streamline your debts: Cash-out refinance

An added benefit of cash-out refinancing is that you can simplify your debt payments. Rather than paying two separate loans (a mortgage and a home equity loan), you’ll only have one single mortgage payment to make when you opt for a cash-out refi.

It may seem like a small consideration, but many people find it easier to manage everything under one loan — especially if you’re already planning to use the funds to consolidate other debt. Although you’re still borrowing the same amount, from a psychological standpoint, only having one debt tied to your home can seem more reassuring than having multiple debts. It’s also simpler to manage payments on one debt versus several.

You don’t need an overly large amount: Home equity loan

Home equity loans and cash-out refis offer fairly similar amounts of funding, but a bigger difference lies in the term lengths offered. You can generally choose term lengths ranging from five to 30 years with a home equity loan, versus just two choices — 15 or 30 years — for a cash-out refi. 

Not everyone needs to take 15 years to pay off the amount they’re looking to borrow. Stretching your repayment out over 15 or more years can seem tempting because your monthly payments will be much less. This comes with added costs, though, because you’ll be paying higher interest costs overall, and you could be in debt for longer than you need. 

Thus, if you can comfortably afford the monthly payments on a shorter-term home equity loan, it’s often better to choose that option. 

You want to speed up your mortgage repayment: Cash-out refinance

Most homeowners choose a 30-year mortgage when they first buy their home. Many people find that their income increases over time, allowing them to comfortably afford even higher payments. You can always send in extra mortgage payments to pay down your current loan balance (assuming your lender doesn’t charge prepayment penalties, that is). 

If you need to borrow money, though, choosing a cash-out refinance with a shorter term length than you have remaining on your current mortgage may help you save additional money. That’s because lenders generally charge lower interest rates on a 15-year loan, as opposed to a 30-year refinance. 

If you have 20 years left on your current mortgage, for example, taking out a 15-year loan may help you pay off your home five years sooner and save money, assuming you can afford the payments. 

You want to save the most money: It depends

It’s not always clear which is the cheaper option, but there are easy ways to find out. 

First, you’ll need to decide: do you want to save money by getting lower monthly payments, or do you want to save money on long-term interest costs? The two are not always the same. If you stretch out your loan to the maximum term length, you may be able to secure lower monthly payments, but at the expense of higher interest charges over the life of the loan. 

Next, you’ll need some idea of the rates, terms, and fees that each option might cost you. You can guesstimate these numbers, or get prequalified for a cash-out refi and a home equity loan with a lender. This doesn’t obligate you to accept the loan, but it can give you a better idea of your real-world costs. 

Finally, use a home equity loan and cash-out refinance calculator to estimate your monthly payments and total loan costs. This will give you the definitive answer to which is the cheapest option, no matter your goals. 

Alternatives

Home equity loans and cash-out refis are two popular options, but they’re not the only way you can access your home equity for low-cost financing. Here are three other possibilities:

• Reverse mortgage: If you’re 62 or over, you can access your home equity with a reverse mortgage. You don’t have to make a monthly mortgage payment because it’ll be repaid from the sale of your home after you no longer need it. 
• Home equity investment (HEI): A home equity investment allows you to trade a share of your home’s future appreciation for a lump sum of cash today – no monthly payments required. Instead, you’ll repay the investment along with that slice of appreciation in 30 years.
• Home equity line of credit (HELOC): A HELOC charges adjustable rates. Its main feature is that you can borrow repeatedly against your home during a predefined draw period. You’ll then pay back any unpaid balance during the repayment period.

The bottom line

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.