Cash-Out Refinance Or Home Equity Loan?

Both a cash-out refinance and a home equity loan let you borrow against the equity you’ve built in your home.

Equity is the difference between what you owe on your mortgage and how much your home is worth. If your home is worth $400,000 and you owe $150,000 on your mortgage, you have $250,000 in equity.

With both a home equity loan and a cash-out refinance, you can borrow against your equity to pay for anything you want. If you use the funds from either product to pay for a home improvement that increases the value of your residence, you can write off the interest you pay throughout the year on your taxes. You must itemize your taxes to claim this deduction.

Home equity loans

Home equity loans and cash-out refinances come with big differences, though.

A home equity loan is a second mortgage. Most lenders allow you to borrow up to 80% of your equity. If you have $250,000 in equity, you can typically borrow up to $200,000 in a home equity loan.

You’ll receive your money in a single payment, which you repay in regular monthly installments with interest. Once you take out a home equity loan, you’ll make two mortgage payments a month, one for your principal mortgage and one for your home equity loan.

These loans do come with closing costs, which typically range from 2% to 6% of your loan amount.

Cash-out refinance

A cash-out refinance replaces your existing mortgage with a new one. But you borrow more than what you owe on your current mortgage, receiving the extra money as cash that you can use however you want.

Say you owe $200,000 on your current mortgage, and you refinance to a new loan of $300,000. You’d get the extra $100,000 as a cash payment. You then repay the entire $300,000 in monthly payments. These payments will vary depending on your interest rate and your new loan’s term. You’ll pay more each month on a 15-year loan than on a 30-year loan. But you’ll pay more in interest with a longer-term mortgage than you would with a shorter-term one.

Cash-out refinances come with closing costs, too, running from 2% to 6% of your new loan amount.

Which is better?

Which loan type is better? Not surprisingly, that depends on your personal situation.

If you are currently paying off a mortgage with a high interest rate, swapping it for a cash-out refinance might make sense. If you can qualify for a lower interest rate, you can drop your monthly payment by hundreds of dollars and significantly reduce the interest that you’ll pay over time. This could make a cash-out refinance a smart financial move.

But maybe your current mortgage has a lower interest rate than you’d get on a new loan today. And maybe you’ve already paid off a good portion of your existing mortgage so that more of your monthly payment goes toward your loan’s principal balance and less toward interest. You might not want to replace this loan with a new one with a higher interest rate. In this case, a home equity loan might be the better option.

A home equity loan might cost less upfront, too, because you are often borrowing less than you would with a cash-out refinance.

The choice usually comes down to the new interest rate you could get with a cash-out refinance. If the drop in interest rate from your current loan to a new one is significant, you may want to consider a cash-out refinance. If not, a home equity loan might be your better option. Work with financial professionals to help you make a decision.

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