Being a homeowner comes with plenty of perks: you get to set roots at your residence, decorate and paint however you want, and above all, use your home as an investment. If you’ve built up equity in your home, you may be looking for other ways to benefit from your investment.
Home equity loans and cash-out refinances are two types of loans consumers can use to take advantage of their home equity by saving money on loan payments, simplifying debt repayment, and access additional capital.
If you’ve considered either of these loan types, it’s important to compare how they work and the benefits and drawbacks of each before you make your decision. In this article, we’ll discuss home equity loans vs. cash-out benefits, drawbacks, and give you the information you need to determine which one is right for your financial situation.
- Home Equity Loan Definition
- Cash-Out Refinance Definition
- Similarities Between Home Equity Loans And Cash-Out Refinances
- Comparing Home Equity Loan Vs. Cash-Out Refinances
- Reasons To Use A Home Equity Loan Or A Cash-Out Refinance
- Which Loan Is Right For Me?
- Key Takeaways
Home Equity Loan Definition
A home equity loan allows you to borrow money using your home equity (the value of your property, minus remaining mortgage) as collateral. Home equity loans are also known as second mortgages.
Cash-Out Refinance Definition
A cash-out refinance is a loan that allows homeowners to convert their existing home equity into cash that they can use for whatever they want.
Similarities Between Home Equity Loans And Cash-Out Refinances
Home equity loans and cash-out refinances are both loan types that use home equity as loan collateral. In addition, they share the following similarities:
- Both typically have fixed interest rates
- Both generally require a post-transaction loan-to-value ratio of 90% or less to qualify
- Both offer lump-sum payments
Comparing Home Equity Loan Vs. Cash-Out Refinances
We’ll dive deeper into how home equity loans and cash-out refis work and when they’re most applicable a little later on in this post. For now, we’ll cover a few of the main differences between home equity loans and cash-out refinances:
- Cash-out refinances offer adjustable rates
- Cash-out refinances are a single loan, not an additional mortgage
- Cash-out refis typically have lower interest rates
- Home equity loan lenders typically pay part or all of the closing costs
Reasons To Use A Home Equity Loan Or A Cash-Out Refinance
Now that you know a little bit about them, let’s discuss why some homeowners choose home equity loans vs. cash-out refinances, and vice versa.
Home Equity Loans
Home equity loans enable you to borrow a predetermined amount of money, for a set term, at a fixed or variable rate, just like a mortgage. This is why home equity loans are considered “second mortgages.” Lenders typically allow homeowners to borrow 80 – 90% of the home’s value in total, which includes both mortgages. Home equity loans generally come with a 15-year payback time frame.
Home equity loans can be used to refinance an existing mortgage or:
- A current home equity loan
- An existing home equity line of credit
If you’ve built up equity in your home, using a home equity loan to refinance can be especially effective when interest rates are high.
Advantages Of Home Equity Loans
- Home equity loans give you the option of fixed payments, which can help borrowers plan for monthly payments.
- You have the option to maintain the rate and term of your first mortgage if you’re happy with it.
- A home equity loan can help to avoid paying mortgage insurance.
Disadvantages Of Home Equity Loans
- Home equity loans often have higher rates than primary mortgages because lenders assume that you’ll pay off your first mortgage before you pay off your second.
- Primary lender liens take precedence over home equity liens, so second mortgage lenders typically charge more because of the added risk they face.
- Home equity loans that are used for expenses other than building, renovating, or buying a home do not qualify for tax-deductible interest, as a result of the 2017 Tax Cuts and Jobs Act.
- Having two mortgages to pay off can complicate your debt repayment efforts.
As you learned above, cash-out refinances share many of the same benefits of home equity loans, but both loan types have their own pros and cons, too. Let’s take a look.
Advantages Of Cash-Out Refinances
- You only have one mortgage to pay off, rather than two separate ones. This is less risky for the lender, which means you’ll likely benefit with a lower rate than a second mortgage.
- Qualifying for a cash-out refinance is typically easier because lenders don’t need to worry about you paying off one mortgage before the other.
- Cash-out refinance rates are typically lower than first mortgages, which means you’re saving more money on interest. Mortgage rates have been dipping since January 2019, the average rate for a 30-year mortgage when this post was written was 3.6%.
- Since these interest rates are lower, you could use the loan to pay off debts with higher interest rates, like your credit card balance or student loans.
Disadvantages Of Cash-Out Refinances
- A cash-out refi will have different rates and terms from your original mortgage, which may not be ideal if you’re happy with your current terms.
- You’ll need to budget for closing costs in order to take out a cash-out refinance.
- You may need to pay mortgage insurance if you borrow more than 80% of your home’s value.
- The amount of equity you have in your home determines how much you have access to borrow. If you don’t have enough equity to meet your goals, a cash-out refinance may not be beneficial for you.
Which Loan Is Right For Me?
Should you opt for a cash-out refinance or a home equity loan? It depends on your financial situation and preferences to determine which loan makes the most sense for you! If you’re unsure, consider speaking with a financial advisor to see how the benefits and drawbacks of each loan type apply to your circumstances.
In general, when evaluating loan types, you may want to consider:
- How much equity you have in your home
- Your current mortgage’s interest rate
- The amount you want to borrow
- How long you need/want to repay the loan
- Whether you want fixed or flexible loan terms
Now let’s take a look at a few examples where home equity loans and cash-out refinances can be most beneficial.
A home equity loan may be a good choice if:
- You want to use a second mortgage so that you don’t need to pay for mortgage insurance
- Current mortgage rates are higher than the rate you got with your existing mortgage
- You want to use your home’s value without impacting your existing mortgage
A cash-out refinance may be a good option for you if:
- You have enough equity to borrow what you want
- You want to consolidate for a lower rate
- You want to make home improvements
- You would like to keep a single mortgage payment rather than multiple
It’s important to note that since both of these loan types use your home’s equity as collateral, you run the risk of having your home foreclosed if you are unable to make your payments.
- Home equity loans and cash-out refis are both loans that use homeowner equity as collateral.
- Both allow homeowners to access home value in the form of lump-sum payments.
- It’s important to consider the pros and cons of both in order to make the best financial decision for your situation.