What Distinguishes a Home Equity Loan From a Cash-Out Refinance?
The key distinction between a cash-out refinance and a home equity loan is that the former is a “first mortgage,” and the latter is a “second mortgage.”
A cash-out refinancing replaces your mortgage while extracting cash from your home’s equity. Because it is a second mortgage, a home equity loan uses your property’s equity solely while leaving your present mortgage in place.
Homeowners like cash-out refinancing when mortgage rates decline and may pay off their mortgage at a cheaper interest rate. However, a home equity loan is frequently preferable when mortgage rates are high.
How Do Cash-Out Refis Work?
A new, bigger loan replaces your previous mortgage when you employ a cash-out refinancing to remove home equity. The new loan pays off your existing mortgage, and any “excess” funds (the difference between your previous and new loan amounts) are returned to you at closing.
A cash-out refinancing combines your mortgage and equity loan into a single loan, leaving you with only one mortgage and one monthly loan payment.
How Do Home Equity Loans Work?
A second mortgage is equivalent to a home equity loan. This means it simply borrows against the cash worth of your house, keeping your existing mortgage intact.
When using a home equity loan, you obtain a second mortgage in addition to your present mortgage. Your available equity determines the amount you may borrow, and you will get the whole loan at closing. The new loan is entirely independent of your current mortgage, so that you will have two separate house loans and two monthly payments.
Pros and Cons of Cash-Out Refinancing vs Home Equity Loans
A cash-out refinance is easier than a home equity loan since it combines your principal mortgage and cash back into a single transaction. You are left with only one loan and one mortgage payment every month.
The disadvantage of a cash-out refinance is that you must refinance your existing mortgage. This implies that closing fees will be greater, and if interest rates have risen since you obtained your initial mortgage, you may wind up paying a higher interest rate on your whole loan sum. This would certainly result in much higher overall interest payments over time.
A home equity loan is slightly more complicated than a cash-out refinancing since it results in two different mortgages and two monthly payments.
However, a home equity loan will not affect your existing mortgage in any way. If you currently have a mortgage with a low-interest rate, keep it in place and pay today’s higher rates only on the amount you borrow from your equity.
Rates on Home Equity Loans vs. Refinancing Rates
The interest rates on home equity and cash-out loans are set, as are the monthly mortgage payments. However, home equity loan interest rates are often higher than cash-out refinance interest rates. This is because lenders view second mortgages as more risky.
Keep in mind that a home equity loan will result in a lesser loan amount than a cash-out refinancing would have. Therefore, even if your interest rate is greater, you only pay interest on the amount of equity you borrow.
In contrast, with a cash-out refinance, the new interest rate is applied to both the cash-back and the remaining loan balance (remember, the old loan balance is rolled into your new cash-out loan). Consequently, if current interest rates are greater than your former rate, you would pay extra interest not just on your equity but also on your whole mortgage debt.
When rates are low, most homeowners favor cash-out refinancing, which allows them to withdraw equity and reduce the interest rate on their current mortgage. To prevent a rate increase on their existing loan balance, homeowners typically prefer a home equity loan or home equity line of credit (HELOC) when interest rates are high.
Home Equity Line of Credit vs. Cash-Out Refinance or Home Equity Loan
When cashing out real estate, home equity loans and cash-out refinancing are just some of the available possibilities. Additionally, consider a home equity line of credit (HELOC).
Home equity lines of credit operate differently than home equity loans and cash-out refinancing. Both alternatives require a one-time cash payment at closing, which you immediately begin repaying. Cash-out loans and home equity loans are comparable to conventional mortgages in this regard.
In contrast, a HELOC is organized as a line of credit. Instead of getting a flat sum of cash at closing, you will receive a card or account with a maximum credit limit. During the “draw term” of your HELOC, you are permitted to borrow, repay, and borrow again (which often lasts up to ten years).
A HELOC is similar to a credit card because you can spend up to your limit and pay interest only on what you borrow. After the draw time, however, you will enter a repayment period during which you must return the outstanding loan sum plus interest, and you will no longer be able to borrow from the credit line.
Notably, HELOC interest rates are often variable, but cash-out refinance, and home equity loan rates are set. If you have a HELOC, you may pay less because you only pay interest on the amount you use. However, if the Fed increases interest rates, your borrowing expenses may increase.
What Is the Best Approach to Cash Out Home Equity?
How do you choose between a cash-out refinancing, a home equity loan, and a home equity line of credit? The decision is heavily influenced by two factors: the purpose of the funds and the state of the current mortgage.
Cash-out refinancing is typically your best option if you can obtain a cheaper interest rate on your existing loan and you’re not near to paying it off. When you can withdraw equity and reduce your mortgage rate simultaneously, it’s a win-win situation.
If refinancing results in a higher interest rate or postpones your payback date and forces you to pay more in the long term, a cash-out refinance is generally not prudent. Consider a home equity loan or home equity line of credit instead.
- If you know just how much money you will need upfront, a home equity loan may be the best option (for instance, for a fixed-cost renovation project)
- A HELOC may be preferable if you require a continuous supply of funds or want access to emergency funds.
Each loan type will have its own set of closing expenses and criteria. There are several factors to consider, so work carefully with your loan officer to determine which cash-back loan best suits your requirements.
FAQ About Cash-Out Refinancing vs. Home Equity Loan
Are Home Equity Loans and Cash Our Refinances the Same?
A home equity loan functions similarly to a cash-out refinancing but is not identical. Refinancing with cash-out will replace your current mortgage with a new loan that provides cash upon closing. In contrast, a home equity loan does not effect your current mortgage. It is a separate loan used to access the cash worth of your house.
Is Refinancing Less Expensive Than a Home Equity Loan?
A home equity loan is typically less expensive when mortgage rates rise than refinancing. It will not affect your interest rate or monthly payments on your current mortgage. In addition, because you are borrowing more money. Overall, the closing charges for a cash-out refinance are often greater than for a home equity loan.
What Are the Downsides of Cash-Out Refinancing?
The biggest downside of a cash-out refinance is that if existing mortgage rates have risen, your rate and monthly mortgage payment might increase if you refinance. This will result in increased interest payments throughout the life of the loan. Cash-out refinance closing charges can also be substantial, ranging between 2 and 5 percent of the overall loan amount. Finally, if your home is nearly paid off, refinancing would lengthen the time it takes to pay off your loan, resulting in higher overall interest paid.
Is Taking Equity Out Smart?
Tapping into your home’s equity might be a wise choice when you need to borrow a substantial amount of money. Since cash-out refis and home equity loans are secured by your property, their interest rates are significantly lower than those of credit cards and unsecured loans. This implies that they are an inexpensive option to fund expensive purchases such as home upgrades or investment property. However, experts often do not advocate cashing out equity for non-investment purposes, such as a new car or an extravagant trip.
Is a HELOC Better Than a Refinance?
If refinancing will increase your mortgage rate, a HELOC is preferable. A HELOC allows you to withdraw cash from your home’s equity without having to refinance your mortgage. In addition, you are not required to use the HELOC after opening it. If you do not use the credit line, there will be no principle or interest to pay back.
Your Next Steps
Home equity loans, home equity lines of credit, and cash-out refinancing are all viable choices for tapping your home’s cash worth.
Since the Covid epidemic, mortgage rates have increased, prompting many homeowners to choose a home equity loan or HELOC over a cash-out refinance. However, what is true for the majority may be different from what is true for you. Among other things, the best option will depend on your credit score, current mortgage, and the worth of your property.
Contact a loan officer to discuss alternatives if you are ready to cash out your home’s equity. Your lender will assist you in comparing loan options, up-front costs, and interest rates to locate the mortgage that best suits your needs.