The Difference Between Cash-Out Refinance and Home Equity Loan
Your home is an investment, and the equity in your home is something you can and should use to reach your financial goals. Cash-out refinances and home equity loans are both ways you can get cash from your home to do things like renovate your home, pay for tuition or consolidate debt.
Let’s look at the differences between cash-out refinances and home equity loans, so you can pick the loan option that’s right for you.
What is a Cash-Out Refinance?
A cash-out refinance is a new first mortgage that allows you to take out some of the equity you’ve built in the home as cash.
You might be able to do a cash-out refinance if you’ve had your mortgage loan long enough that you’ve built equity in the home. But most homeowners find that they’re able to do a cash-out refinance when the value of their home climbs. If you suspect your home value has risen since you bought your home, you may be able to do a cash-out refinance.
How this Refinance Works
When you do a cash-out refinance, you replace your existing mortgage with a new one. The loan amount on the new mortgage is higher than the amount you currently owe. After loan funds are disbursed, you pocket the difference between your new loan amount and your current mortgage loan balance – minus the equity you’re leaving in your home and any closing costs and fees.
Here’s an example: Your home is worth $200,000, and you owe $100,000 on your mortgage. To take cash out, you usually need to leave 20% equity ($40,000) in the home. If you were to refinance your home with a new loan amount of $160,000, you’d get to pocket $60,000, minus closing costs and fees.
Of course, your monthly payments would increase to account for the new loan amount. You can estimate your new monthly payments with our refi calculator.
How much equity can you cash out of your home?
When you do a cash-out refinance, you usually can’t get a loan for the entire value of the home. Many loan types require that you leave some equity in the home.
To qualify for a cash-out refinance, Federal Housing Administration (FHA) and conventional loans require that you leave 20% equity in your home. VA loans are an exception, as they allow you to get a cash-out loan for 100% of the value of the home.
Using your cash-out refi funds
The cash you get from a cash-out refinance is tax-free and can be used in any way you like. Most homeowners who do a cash-out refinance use the money for renovations, but the money is yours to use however you see fit.
What is a Home Equity Loan?
A home equity loan is a second loan that’s separate from your mortgage, and it allows you to borrow against the equity in your home.
Unlike a cash-out refinance, a home equity loan doesn’t replace the mortgage you currently have. Instead, it’s a second mortgage with a separate payment. For this reason, home equity loans tend to have higher interest rates than first mortgages. Rocket Mortgage® is now offering the Home Equity Loan, which is available for primary and secondary homes.
How this Equity Loan Works
Since a home equity loan is an entirely separate loan from your mortgage, none of the loan terms for your original mortgage will change. Once the home equity loan closes, you’ll receive a lump-sum payment from your lender, which you’ll be expected to repay – usually at a fixed rate.
Loan Restrictions
Lenders will rarely allow you to borrow 100% of your equity for a home equity loan. The maximum amount you can borrow varies depending on your lender and credit score, but you could borrow up to 90% of the value of the home. As with a cash-out refi, the amount you can borrow will also depend on factors like your credit score, debt-to-income ratio (DTI) and loan-to-value ratio (LTV).
What are the similarities between cash-out refinance and home equity loans?
- You get your money almost immediately. Whether you choose a cash-out refinance or a home equity loan, you walk away with a lump-sum cash payment within 3 business days after you close. The waiting period is offered because you have a right of rescission on a refinance, meaning you can change your mind. Otherwise, you can spend the money on anything you need.
- You borrow against the equity in your home. Both these loans use your home as collateral, which means you can get lower interest rates for cash-out refinances and home equity loans than other types of loans.
- You usually can’t take 100% equity from your home. Most lenders and loan types require borrowers to leave some equity in the home..
What are the differences between home equity loans vs refinances?
- Cash-out refinances are first loans, while home equity loans are second loans. Cash-out refinances pay off your existing mortgage and give you a new one, while a home equity loan is a separate loan that’s considered a second mortgage.
- Cash-out refinances have better interest rates. Since cash-out refinances are first loans – meaning they’ll be paid first in the case of a foreclosure, bankruptcy or judgment – they typically have lower interest rates.
When a Home Equity Loan makes sense
If refinancing your mortgage would force you to get a significantly higher interest rate, it might make sense to look at alternatives, like home equity loans. However, the higher interest rate on the home equity loan might not be worth it either. It’s important to crunch the numbers to determine if a home equity loan makes sense for you.
You may also want to look into a home equity line of credit (HELOC) to determine whether a HELOC or cash-out refi makes more sense for you.
When a Cash-Out Refinance makes sense
If refinancing your mortgage would force you to get a significantly higher interest rate, it might make sense to look at alternatives, like home equity loans. However, the higher interest rate on the home equity loan might not be worth it either. It’s important to crunch the numbers to determine if a home equity loan makes sense for you.
You may also want to look into a home equity line of credit (HELOC) to determine whether a HELOC or cash-out refi makes more sense for you.
FAQs for Home Equity Loan vs Refinance
Now, let’s answer some of the most frequently asked questions about home equity loans versus a refinance.
Is a home equity loan cheaper than a refinance?
Home equity lines of credit and loans typically come with significantly lower closing costs than cash-out refinances. Sometimes, the lender will even absorb these costs, too.
So while a HELOC or home equity loan carries higher interest rates, if those rates are comparable to your current mortgage rate, your best choice may be a home equity loan – especially if you’re only borrowing a small amount of money.
What are the alternatives to a HELOC or cash-out refinance?
If you’re considering refinancing, but you only need a little liquidity for a small project or to pay off a little debt, you may instead consider either a small personal loan or a credit card with low interest rates. Either option would allow you to avoid the closing costs associated with refinances, home equity loans and HELOCs.
Will I lose my home equity when I refinance?
In short, no – you won’t lose equity when you refinance your home. Your home’s equity will fluctuate based on how much repayment you’ve made toward your home loan and how the market affects your home’s value. Pulling from your home’s equity to make improvements or to fund renovation projects can also help increase your home’s equity.
The Bottom Line
While both loan options allow you to borrow against the equity in your home and access the cash immediately, the loan type and interest rates may make one a better choice for you.
Ready to get started? Apply online to see how much cash you could get from your home in a cash-out refinance.
Patrick Chism
Original Publish Date: March 7, 2024
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