Cash-Out Refinance vs. Home Equity Loan

Both a cash-out refinance and a home equity loan allow homeowners to borrow from the equity they’ve built in their home — the current value of the home minus how much they owe on their mortgage. Tapping into your home’s equity can be a good way to fund a home improvement project, make needed home repairs, cover education costs or pay off non-mortgage debt. However, cash-out refinances and home equity loans work differently, and both come with costs.

Let’s explore how each of these options works and what you should consider before deciding to get either.

What is a cash-out refinance?

A cash-out refinance is a new, larger mortgage that replaces your existing one, and you receive the difference between your current mortgage and the new one in cash. Like a regular mortgage, a cash-out refinance uses your home as collateral (something of value you possess that a lender may take if you fail to repay the loan). The larger mortgage amount is based on the equity you’ve built in your home.¹ The new, larger mortgage pays off your old one, and then you repay the new loan with a single monthly payment. Your outstanding mortgage balance will increase, but you’ll receive cash that you can use for a wide range of purposes, from debt consolidation to home renovations to educational expenses.²

When you apply for a cash-out refinance, the lender will typically get an appraisal for your home to determine its current value and the equity you currently have. You usually have to pay for the appraisal upfront before closing on your new loan, and you may have other closing costs, such as a loan origination fee and a refinancing fee. Generally, you’re required to keep at least 20% equity in your home, so your new loan amount tends to be limited to 80% of your home’s current appraised value.³

When you might use a cash-out refinance

Here are some situations in which a cash-out refinance could be beneficial:

• You want a lower interest rate: In some circumstances, a cash-out refinance may allow you to refinance your mortgage into a lower interest rate. If federal interest rates have gone down or your credit score has improved since you applied for your original mortgage, a cash-out refinance could get you a more favorable interest rate.⁴
• You plan to stay long term: A cash-out refinance increases the amount you owe on your home and may extend the repayment term to give you lower monthly payments. But building back equity takes time, so if you’re interested in selling your home within a few years, you may make a smaller profit because you have less equity.
• You want to keep one monthly payment: A cash-out refinance allows you to keep a single monthly payment for your home, unlike a home equity loan, which requires you to make an additional monthly payment.

What is a home equity loan?

Also known as a second mortgage, a home equity loan is a secured loan that allows you to borrow against your home’s equity using your home as collateral.

With a home equity loan, you keep your original mortgage and take out a new loan based on the amount of equity you have available. You typically repay a home equity loan in predictable monthly payments for a set repayment term. The interest rate is often fixed, but it may be a higher interest rate than your original mortgage rate.⁵ The loan will be distributed as a lump sum.

To qualify for a home equity loan, you’ll have to get your home appraised to determine your equity and how much you can borrow, and you’ll typically have to retain 15-20% of the equity.⁶ Like a cash-out refinance, you’ll need to pay closing costs, but they’ll usually be lower because you’re borrowing a smaller amount.⁷ Remember that a home equity loan is a new loan separate from your mortgage, so you’ll have two monthly payments to make instead of one.

When you might use a home equity loan

Some situations in which a home equity loan may make sense include:

• You already have a low mortgage interest rate: If you’re locked into an interest rate that’s lower than the current market rate, you may not want to refinance. In this case, a home equity loan may suit your needs better than a cash-out refinance.
• You’re renovating with a plan to move: A home equity loan can be a good tool to invest in a home improvement project that raises its resale value. Using a home equity loan on a major home renovation or addition could potentially increase your home’s value enough to pay off both mortgages and earn a profit after a sale.
• You want to borrow a smaller amount: If you want to borrow less than the full amount of equity available to you, a home equity loan may be simpler because it doesn’t involve restructuring your entire mortgage.

Cash-out refinance vs. home equity loan

Let’s take a broader look at the similarities and differences between a cash-out refinance and a home equity loan:

	Cash-out refinance	Home equity loan
Number of loans	1	More than 1
Interest rates	Generally lower than home equity loan interest rates8	Generally higher than cash-out refinance interest rates9
Closing costs	2-6% of loan principal10	1-5% of loan principal11
Appraisal	Generally required	Generally required
Equity needed	At least 20%	At least 15-20%
Risk	Risk of foreclosure if you fail to make payments	Risk of foreclosure if you fail to make payments

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Know your options before you borrow

Home equity is earned over time, and you can tap into it with a cash-out refinance or a home equity loan to finance home improvements, education or emergency expenses. Take the time to evaluate both options side by side and consider your homeownership plans before making a decision. Do your research and find a trustworthy lender who can help you make the best decision for your situation.

Sources

1, 3, 5, 7, 10, 11 https://www.bankrate.com/home-equity/refinance-vs-home-equity-loans/
2 https://www.consumerfinance.gov/about-us/newsroom/cfpb-report-finds-cash-out-mortgage-refinance-borrowers-improve-credit-scores/
4 https://www.bankrate.com/mortgages/cash-out-refinancing/
6 https://consumer.ftc.gov/node/78380
8, 9 https://www.bankrate.com/mortgages/how-to-get-the-best-cash-out-refinance-rate/