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Cash-Out Refinance Vs. Home Equity Loan: Which Is Best For You?

Sarah Li Cain6-minute read
February 10, 2022

There are a few ways you can tap in your home equity, each with its own advantages and disadvantages. The two most common ways to access your home equity are cash-out refinances and home equity loans.

That being said, both have key differences — you’ll want to compare the characteristics of a cash-out refinance vs. home equity loan so you can determine which one is best for you.

Cash-Out Refinances And Home Equity Loans: Similarities

A cash out refinance and home equity loan are two kinds of loans you can use for most purposes, such as home improvement projects to add value to your home, home repairs, paying down high interest debt, and paying for your child’s college education.

Most homeowners like these types of loans because they tend to offer a lower interest rate compared to other types such as personal loans and credit cards. Plus, since your home equity may be higher than what other types of loans allow, either option can be a smart choice for those who want to take out a relatively high sum of money.

With both types of loans, you need to keep some equity in the home after the transaction is complete — though there are some exceptions with certain VA loans. The amount of home equity you need to keep in your home is typically anywhere between 10% – 20% for your primary property. If you’re looking to access equity in a second home or investment property, you may need to leave more equity in the home.

Both cash-out refis and home equity loans come with fixed and adjustable options and borrowers get a lump sum payment, meaning you get the proceeds for the loan at one time.

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What Is A Cash-Out Refinance?

A cash-out refinance is essentially getting a new home loan, except you’re borrowing more than what you owe on your current mortgage. What happens is that you’ll take out a new loan, pay off your current mortgage, and the difference you’ll get in cash at closing. This cash can then be used for almost any purpose.

The “cash out” amount you get will depend on your home equity — your lenders will require you to go through an appraisal to determine the current value of your home. The more you’ve paid down your home, the more equity you have, and hence the more cash you can borrow. The same goes for if home prices have gone up in your area — most likely, your home equity has also gone up.

Once you do a cash-out refinance, you then pay it back on monthly installments according to your loan terms.

Pros Of A Cash-Out Refinance

A cash-out refinance has the following benefits:

  • You only have one mortgage payment since you replaced your old mortgage with the higher cash-out refi payment
  • Since your primary mortgage is your first lien, it carries less risk for the lender which could help you get a lower interest rate
  • You can choose from fixed or adjustable mortgage rates

Cons Of A Cash-Out Refinance

There are downsides to taking cash out on your primary mortgage:

  • You’re increasing your mortgage balance by taking cash out and potentially adding years to your term
  • You could end up not needing all the money you take out in a lump sum

What Is A Home Equity Loan?

Also known as a second mortgage or equity loan, a home equity loan is a type of loan where homeowners can borrow against their home equity. Think of it as similar to a mortgage since you’re using your home as collateral — that’s why it’s usually referred to as a second mortgage.

The amount you can borrow is based on a certain percentage of your home equity — the difference between your home’s current value and your mortgage balance. Lenders use a combined loan-to-value (CLTV) ratio — typically 80% – 90% — of your home’s appraised value to arrive at a loan amount.

Keep in mind that’s only one aspect of determining whether you qualify for a loan. Like other types of home loans, lenders will consider your credit history, income and assets. Once you’re approved, you’ll receive the amount in a lump sum and pay it back in regular installments.

Pros Of A Home Equity Loan

The following are advantages of home equity loans:

  • You don’t have to touch your primary mortgage — you can keep your interest rate on your primary mortgage if rates now are significantly higher than they were when you initially got your mortgage.

Cons Of A Home Equity Loan

Home equity loans do have certain disadvantages:

  • It’s a second mortgage, so it means two payments
  • Because the mortgage is the second lien, you’ll have a higher rate than you would with a primary mortgage to cover the increased risk to the lender
  • It’s a lump sum, so there’s not the financial flexibility compared to a home equity line of credit (HELOC)

Home Equity Loan Vs. HELOC

Home equity loans are paid out as a lump sum then you repay it over time, usually for both interest and the principal at the same time. With a home equity line of credit (HELOC), however, loan terms are different in that the loan is a line of credit, typically with adjustable interest rates, whereas with home equity loans, rates are usually fixed.

With a HELOC, you’ll agree to a certain loan term like 30 years split into two time frames: a draw period and a payback period. You’ll know beforehand what your draw period will be. During this time, you get access to an account to make withdrawals from, and pay interest on any funds you take out. You can also replace funds if you wish. It’s similar to how a credit card works, or other types of revolving credit.

Depending on the lender, you may have to make minimum withdrawals each time you want to take money out, or there could be a fee for doing so. But for those who want to have access to money and aren’t sure of how much they’ll need, a HELOC might be the better option.

At the conclusion of the initial draw period, the loan is then fully amortized to be paid back over the remainder of the term. You can’t take additional funds out of the HELOC at this point and you’re paying back both the interest and principal.

There are also HELOCs where you make one much bigger balloon payment at some point during the payoff period to fully satisfy the terms of the loan. It’s important to understand what you’re getting when you sign up for a HELOC.

Cash-Out Refinance Vs. Home Equity Loan: Differences

With a cash-out refinance, you’re taking out a new primary mortgage — you’re increasing the outstanding loan balance and getting a new interest rate with a new type of home loan. This means you’re replacing your current mortgage with a new one, which differs from a home equity loan where you’re taking out an additional loan.

In many cases, you could pay a higher interest rate for a home equity loan because lenders perceive it as a higher risk. That’s because if you default on your loan, your primary mortgage lender has the right to claim the proceeds from selling your collateral (your home) first — remaining funds are then given to your home equity loan lender.

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Deciding Between A Cash-Out Refinance And Home Equity Loan

When it comes to deciding between a cash-out refinance and a home equity loan, homeowners should consider their circumstances first to determine which option is best for them.

When Might A Cash-Out Refinance Be Best?

A cash-out refinance can be the better choice if you’d rather deal with one mortgage payment than two. In other words, if you want to simplify your loan payments, a cash-out refinance is smarter because you don’t have to worry about multiple due dates and repayment terms.

In general, a cash-out refinance could offer lower interest rates so it could save you more money in interest in the long run. However, if you don’t want to take out a loan with a lump sum payment — such as if you don’t know how much money you’ll need for a home improvement project — you may be better off taking out a home equity loan.

When Might A Home Equity Loan Be Best?

Home equity loans can be a smart choice if you still want to have a lump sum payment and can find a more competitive rate than a cash-out refinance. Or, if you’d rather have access to cash over time, a HELOC is a good choice, since you’ll have access to a draw period over a certain number of years. That way, if you have multiple repairs, home improvements, or expenses you want to pay down over time, you can withdraw from a HELOC (assuming it’s within the draw period).

The Bottom Line

Both cash-out refinances and home equity loans allow you to potentially tap into your home equity so you can use the cash for almost any purpose. Considering both these loans carry a high risk since they’re tied to your home, you’ll want to weigh your decision carefully. Consider consulting with a financial expert if you need help deciding between a cash-out refinance and home equity loan. If you’re ready to get started with a refinance, consider getting approved with Rocket Mortgage®.

Sarah Li Cain

Sarah Li Cain is a freelance personal finance, credit and real estate writer who works with Fintech startups and Fortune 500 financial services companies to educate consumers through her writing. She’s also a candidate for the Accredited Financial Counselor designation and the host of Beyond The Dollar, where she and her guests have deep and honest conversations on how money affects our well-being.