Cash-Out Refinance Vs. Home Equity Loan
- Home equity loans and cash refinances allow you to turn the equity in your home into cash.
- A cash refinance replaces your existing mortgage with a mortgage with a higher balance.
- A home equity loan is considered a second mortgage and comes with an additional monthly payment.
Owning a home allows you to build up equity that you can turn into cash when you need it, whether it’s for home repairs, your child’s school fees, to pay off debts or for any other financial need.
Cash-out refinancing and home equity loans are two of the most popular tools available to do this. But they are not created equal. Here’s what you need to know about each to help you decide which is the best choice for your situation.
Cash-In Refinance vs. Home Equity Loan: At a Glance
Cash-in refinance and home equity loans both allow you to access the equity in your home in one lump sum payment.
The main difference between the two is:
- cash refinancing replaces your current mortgage with a larger loan. You get the difference between the two cash balances.
- A home equity loan is a new loan added to your existing mortgage. It comes with an additional monthly payment.
Either way, there are no restrictions on how you can use the money. Many people use cash refinances and home equity loans to pay
home renovations
or repairs. Since mortgages often come with lower interest rates than other financial products, some homeowners find cash refinancing a good way to consolidate other debts.
What is cash-in refinancing?
A cash-out refinance works like this: you apply for a new mortgage for a larger amount than you currently have. Once approved, this loan is used to pay off your old loan and you get the difference back in cash at closing.
Cash-in refinancings have adjustable or fixed interest rates with terms between 15 and 30 years. Typically, your loan-to-value (LTV) ratio can be as high as 80% of your home’s value. There will also be
closing costs
– usually around $5,000 on average.
The biggest advantage of a cash-in refinance is that there are no additional payments involved. It also usually comes with a lower interest rate than a home equity loan.
“It’s the cheapest way to borrow against your home equity,” says Melissa Cohn, regional vice president of William Raveis Mortgage.
With a cash refinance, your mortgage interest payments are tax deductible. Depending on your rate and your loan balance, this could significantly reduce your taxable income.
The downside of cash-in refinancing is that it replaces your current mortgage, which may mean swapping a low rate for a higher rate. There are also closing costs to consider. If you think you might sell the house soon, these costs might not be worth it.
“If you’re going to borrow money for the long term, cash-out refinancing makes sense,” Cohn says.
Cash Refinance Example
Let’s say your house was worth $500,000 and your current mortgage balance was $300,000.
The cash-out refinance process would look like this:
- You would apply for a new mortgage. Since cash refinances typically allow an LTV of up to 80%, this means you can request up to $400,000 in financing ($500,000 x 0.80).
- You submit the required financial documentation. Lenders typically require bank statements, pay stubs, tax returns, and W-2s, among other items.
- Have your home appraised. In most cases, your lender will want to verify the value of your home with a new appraisal.
- You would close the loanand the new loan would be used to pay off the old mortgage balance, leaving you with a $100,000 excess.
- You’ll get that $100,000 in a lump sum payment a few days after closing.
What is a home equity loan?
A home equity loan is a type of second mortgage. Unlike cash-out refinancing, it does not replace your current mortgage. Rather, it is a loan that is added to your original mortgage, which means that you will have two monthly payments.
Home equity loans typically come with fixed interest rates and terms ranging from five to 30 years. These loans also come with closing costs, although they’re usually lower than what you’ll see with a cash refinance. Some lenders will even cover them entirely. In most cases, home equity loans allow you to access up to 80% of the value of your home on both your home equity loan and your primary mortgage. Some lenders may have limits as high as 90% for certain borrowers.
The main disadvantage of a home equity loan is that it comes with a second monthly payment. Rates may also be higher and your interest charges may not be tax deductible. With home equity mortgages, you can only deduct interest if you use the funds to “buy, build, or substantially improve” your home. And even in this case, you will have to detail your declarations to benefit from this deduction.
In contrast, home equity loans allow you to keep the terms of your original mortgage, which can be advantageous if you are very far into your amortization schedule when more of your payments are allocated to your principal balance and not the interest. It’s also a good idea if interest rates on traditional mortgages are rising and you don’t want to lose the low rate you already have.
“For homeowners whose prime mortgage rate is lower than current market rates, a home equity loan is more likely to be the best choice,” says Nicole Straub, senior vice president and head of Discover Home Loans. “By choosing this option, it allows them to keep the low rate they have while allowing them to tap into the equity in their home.”
Example of a home equity loan
Let’s say your home is worth $500,000. Since home equity loans typically allow loan-to-value ratios of 80%, you can access up to $400,000 on your primary mortgage and on a new home equity loan. If your current mortgage balance was $350,000, for example, a home equity loan could likely offer you up to $50,000 in upfront cash ($400,000 – $350,000).
To get your home equity loan, you need to apply with the lender of your choice, submit documents and have your home appraised. Once you have paid your closing costs and signed the documents, you will receive your lump sum payment a few days later. You will then start making monthly payments for your home equity loan starting the following month.
put it all together
Home equity loans and cash refinance can help you turn equity into cash. But the best choice depends on your unique budget, the terms of your original mortgage, and your long-term plans as a homeowner.
Either way, home equity loans and cash refinances will likely save you money over other financial products you may be considering.
“Home equity loans and cash refinances are types of secured debt with a generally lower average interest rate than what you’ll find with other types of unsecured debt, such as credit card or personal loans. “, explains Straub.
If you are unsure which product is right for you, contact a mortgage broker or financial advisor for assistance. You can also ask lenders for quotes for both products and compare the two options side by side.