Home Equity Loan vs. Cash-Out Refinance: How to Choose Which One to Tap Your Home’s Value

If you’ve built up a lot of home equity and need cash, you can choose a home equity loan, or a cash-out refinance.

  • Home equity loans and cash-out refinances allow homeowners to convert their equity into cash. 
  • Cash-out refinancing uses a mechanism that replaces the existing home loan with a larger balance loan. 
  • Home equity loans are considered second home loans. As such, they attract an additional monthly payment.

Homeownership accords you an opportunity to build up equity that you can convert into cash whenever you need some money. Whether you need to repair your home, pay off debt, send your kids to college, or meet any financial obligation, you can use your home equity to seek funding.

Home equity loans and cash-out refinancing are two popular financial tools available to homeowners who seek to convert the equity they hold in their homes into cash. However, they are not exactly the same. Herein we’ll delve into these products and help you decide which is the better option.

home equity loan

Home Equity Loan vs. Cash-Out Refinancing in a Nutshell

Home equity loans and cash-out refinancing allow homeowners to access their home equity in one lump-sum payment.

Their main differences include:

A home equity loan, as the name suggests, is a new loan on top of your existing mortgage. As such, it attracts an additional monthly payment.

Cash-out refinancing involves replacing your current mortgage loan with a larger loan. When you opt for a cash-out refinance, you’ll receive the difference between the old and new mortgages.

With both tools, homeowners are not restricted in how they can use the money. However, many people use home equity loans, and cash-out refinances to pay for home improvement and repairs. Additionally, some homeowners use cash-out refinancing to consolidate their debt since mortgage loans typically attract lower interest than other types of loans.

An In-Depth Look at Home Equity Loan

When you take a home equity home, you take a second mortgage. This is different from cash-refinancing, which replaces your existing home. It’s a loan you take in addition to your existing home loan, resulting in two monthly payments.

Home equity loans have fixed interest rates and terms spanning 5 and 30 years. While these loans also attract closing costs, they are typically lower than the closing cost you get in a cash-out refinance. Some lenders will cover the closing costs entirely. 

Home equity loans allow homeowners to access up to 80% of their home value, considering your primary mortgage and home equity loan. However, some lenders have limits as high as 90% for certain borrowers.

The main demerit of drawing from your home equity using a home equity loan is the second monthly payment. Additionally, the loan may attract higher rates, and you may be unable to deduct the interest cost from your taxes. 

With this financial tool, you can only deduct the interest if you use the funds to build, buy, or substantially improve the property. Even then, you must itemize your returns to make the interest tax deductible.

Note: Before you take out this loan, carefully inspect your household’s financial wellbeing. The second payment may force you to rearrange your budget.

On the other hand, this type of loan is perfect if you want to keep your original mortgage. Retaining your terms might be good if you’re well into your amortization schedule. This is when more of your payments are used to repay the principal balance and less to pay the interest.

It’s also a good option when interest rates on traditional mortgages are on the rise, and you’d like to retain the low rates that are part of your current mortgage.

Nicole Straub, the SVP and head of Discover Home Loans, advises homeowners with mortgages below the current market rates to consider the home equity loan rather than the other loan. Using home equity allows you to tap into your home equity while retaining the below-market rates of your primary mortgage.

Pros

  • Lower closing costs
  • Homeowners can utilize the money from the loan for anything
  • Homeowners can keep the rates and terms of their primary mortgage

Cons

  • The loan uses your property as collateral
  • Typically attracts closing costs
  • Attracts a second monthly payment
  • The interest cost is only tax-deductible under special circumstances 

Example of a Home Equity Loan

Let’s say your home has a value of $500,000. Given that your home equity loans have a loan-to-value ratio limit of 80%, you can access as much as $400,000 across your primary mortgage and your new home equity loan. Let’s say your current mortgage balance is $250,000; you can access a home equity loan of up to $150,000 upfront (that is, $400,000-$250,000).

Applying for a home equity loan, you file an application with your lender of choice, submit all necessary documents, and have your house appraised. After you sign the paperwork and pay for the closing costs, you’ll receive your lump-sum payment a few days later. The following month after loan disbursement, you’ll start to make monthly payments.

An In-depth Look at Cash-Out Refinancing

A cash-out refinance works differently than home-equity finance. In simple terms, you’ll apply for a larger mortgage than your current loan. When approved, your new loan pays off the old loan, and you get the difference between the new and old loan at closing.

Cash-out refinances can use fixed or adjustable interest rates. The terms span between 15 and 30 years. Just like home equity loans, cash-out refinances typically have a loan-to-value limit of about 80% of the value of your home. It also comes with closing costs, which are usually about $5,000.

One of the advantages of using cash-out refinance to turn your home equity into cash is that it does not attract extra monthly payments. Additionally, it is typically available at a lower interest rate than your home equity loan.

Melissa Cohn, the regional vice president of William Raveis Mortgage, reckons it is the cheapest way to borrow against your home’s equity.

Another advantage is that you can deduct mortgage interest payments from your taxes. Depending on your loan balance and rate, the deduction can reduce your taxable income significantly.

Note: You need to itemize your returns to write off your mortgage. Additionally, doing this means you forgo the standard deduction, which may leave you with a higher or lower tax burden. Consult a professional before you itemize your returns.

Conversely, cash-out refinance replaces your current mortgage with a new one. It means you could trade a lower interest rate with your primary loan for a higher one. There is also an expensive closing cost, and it might be worth it or not.

“If you’re going to borrow the money long-term, cash-out refinancing makes sense,” Cohn says.

Nonetheless, Cohn reckons that cash-out refinancing might make sense if you borrow money long-term.

Pros

  • Potentially lower interest rates
  • You are left with one monthly mortgage payment
  • Tax-deductible interest
  • You can use the money for anything

Cons

  • Higher closing costs
  • Replaces your primary mortgage with a mortgage that has a new rate, term, etc.
  • Uses your property as collateral
  • Example of cash-out refinancing
  • Let’s say your property is $500,000, and you have a mortgage balance of $250,000.

Your cash-out refinancing process will go as follows:

You’ll apply for a new mortgage. A cash-out refinance usually allows up to an 80% loan-to-value limit, so you can apply for a loan valued at as much as $400,000.

You’ll submit all of the necessary documents. Some documents you need include a bank statement, tax returns, pay stubs, W-2s, and other items. 

You’ll also have your home appraised. Typically, your lender will want to verify the value of your home with a new appraisal.

After you close the loan, the new loan will pay off the old loan balance of $250,000, leaving you with $150,000. As such, you will receive the balance of $150,000 in one lump-sum payment a few days after closing.

Note: we’ve used hypothetical numbers in our examples. Every homeowner will have a different situation, and the exact funds you can access will depend on the value of your home, how much equity you’ve accumulated in your home, and your credit score.

Putting It All Together

Cash-out refinancing and home-equity loans are helpful financial products that help convert your equity into cash. The best choice between the two will depend on your unique budget, your long-term plans, and the terms of your primary mortgage.

Whichever product you choose, you are likely to save money compared to using other loan products.

Straub acknowledges that cash-out refinances and home-equity loans are forms of secured debt with an average interest rate lower than what is possible with unsecured debt, including personal and credit card debt.

If you do not know which of the two products is best for your particular situation, consult your financial advisor or talk to a mortgage broker. Alternatively, ask lenders to quote for both and compare the 2 options side by side.