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If you’ve built up equity in your home, you might be able to do a cash-out refinance or take out a home equity loan, depending on your situation. These options provide two ways to access your home’s equity and use it to fund significant expenses, such as home improvements, debt consolidation, or college tuition.
Let’s examine how cash-out refinances and home equity loans work so you can choose the option that suits your needs.
In this article
- How does a cash-out refinance work?
- How does a home equity loan work?
- Cash-out refinance vs. home equity loan: Which is the better option?
- What are the best ways to use a cash-out refinance or a home equity loan?
- The bottom line
How does a cash-out refinance work?
A cash-out refinance works by replacing your existing mortgage with a new mortgage loan for more than you owe on your house. The new loan could either be an adjustable-rate or fixed-rate mortgage, depending on the loan type you choose. And it typically includes the remaining balance on your primary mortgage, plus an amount you “cash out” from your equity.
As its name suggests, the purpose of a cash-out refinance is to get cash out of your home equity. Once the lender disburses the funds, you can keep the difference between the amount of your current loan and the new loan balance — minus any closing costs and fees.
Here’s an example of a cash-out refinance at work: Say your home is worth $300,000, and you owe $100,000 on your existing mortgage balance. In this case, you have $200,000 in equity in your home. Generally, banks might be willing to lend up to 80% of a home’s value, which comes out to $240,000 in this case. So with a cash-out refinance of $240,000, you’d use $100,000 to pay off the remaining balance on the original loan, and you’d be borrowing $140,000 against your home’s equity.
Homeowners can use the money from cash-out refinance loans as they wish, but some uses generally make more financial sense than others. For example, you might be able to use the money to pay off debt or fund a home renovation that increases your home’s value.
Pros of a cash-out refinance
- Interest rates tend to be lower than what you might see with other loan products.
- If current interest rates are lower than the rate on your original mortgage, you could access money from your equity and lower your mortgage rate, too.
- Interest payments may be tax-deductible if you use the funds to improve your home.
Cons of a cash-out refinance
- With your home as collateral on the loan, you could risk losing your home to foreclosure if you cannot make your monthly mortgage payments.
- Closing could take 30 to 60 days or longer to process, which might be longer than other types of loans.
- Closing costs are typically 2% to 5% of the mortgage, which could negate some of your potential savings.
How does a home equity loan work?
A home equity loan can also allow you to tap into your home’s equity and borrow a lump sum, which you must repay over the loan term at a fixed rate.
However, unlike a cash-out refinance that replaces your original mortgage, a home equity loan acts as a second mortgage with its own interest rate and repayment terms. That means you’ll make payments on the home equity loan in addition to your first mortgage loan payments.
Of course, you need to have equity available in your home to qualify. The amount you could be approved for will depend on the amount of available equity in your home, as well as your income, creditworthiness, and other factors. Additionally, the amount you can borrow with this type of loan is typically limited to 85% of the equity in your home.
Homeowners can choose to use the funds from a home equity loan for any purpose. Here are some of the most common reasons borrowers might take this type of loan:
- Consolidating high-interest credit cards and other debt
- Financing home improvement projects
- Buying an investment property
- Paying for higher education tuition and related expenses
- Starting a business
Pros of a home equity loan
- You get a manageable repayment plan with fixed monthly payments for the duration of your loan term.
- With good credit, home equity loan interest rates may be lower than what you’d get with credit cards or personal loans.
- Interest might be tax-deductible through the mortgage interest deduction if loan proceeds are used to buy, build, or substantially improve your home, according to the tax code.
Cons of a home equity loan
- Lending requirements can be strict. Since the 2008 housing crisis, home equity loans are no longer a simple rubber-stamp operation.
- The lender could foreclose on your home if you fail to repay the loan.
- You’ll lose equity in your home, which could be tricky if you plan to sell your home soon.
- If home prices drop in your area, you could owe more between your mortgage and home equity loan than your home is worth.
Cash-out refinance vs. home equity loan: Which is the better option?
If you have equity in your home, a cash-out refinance or a home equity loan could both potentially make sense — especially if you don’t plan on moving soon. You’ll typically need some time to rebuild your equity after you borrow. Figuring out how to get a loan that best suits you and your family will depend on your unique situation, budget, and goals.
When a cash-out refinance might be better
Cash-out refinancing could make the most sense if your budget is tight, and you need a single, affordable payment each month, or if:
- You aren’t sure whether you can qualify for a home equity loan’s more rigid lending criteria.
- You want to take advantage of market interest rates that are lower than the rate on your current mortgage.
- You want the lower payments that come with a lower interest rate.
When a home equity loan might be better
A home equity loan may be a better choice if you’re certain you can repay your loan quickly. And although the monthly payments may be higher with a shorter-term loan, you’ll typically pay less interest.
Home equity loans may be a better choice when:
- A second monthly payment is well within your budget.
- Market interest rates are higher than the rate on your current mortgage and you don’t want to risk losing that rate through a cash-out refinance.
What are the best ways to use a cash-out refinance or a home equity loan?
If you have high-interest debt, improving your financial health could be a good reason to refinance your mortgage or take out a home equity loan. For example, if you can pay off high-interest credit cards with a low-interest loan, that could make sense, provided you follow a sound repayment plan.
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As long as you can afford the loan, using funds from a cash-out refi or home equity loan to renovate your home might also be a good investment. After all, a renovation could add value to your home. Remember, however, the longer you make payments on a loan, the more you’ll pay in interest charges.
Finally, accessing equity could potentially be a good choice if the funds are used for higher education and professional degree programs. If completing a program leads to opportunities with higher income potential, you could theoretically be in a better position to repay the loan while earning more money.
Can a cash-out refinance hurt your credit score?
When you take out a cash-out refinance loan, it could impact your credit score in a few ways: First, when you apply for the loan, the lender will initiate a hard inquiry into your credit history, which might cause a small and temporary drop in your score.
Finally, replacing your loan with a larger loan balance could increase your credit utilization ratio, which accounts for 30% of your FICO credit score. Credit utilization is the amount of credit you’re using compared with the amount of credit available to you. Generally, the lower your credit utilization ratio, the better.
How much can you borrow with a home equity loan?
The easiest way to determine how much you could potentially borrow with a home equity loan is to divide the outstanding balance on your mortgage by the home’s current value. The resulting number is your loan-to-value (LTV) percentage. Generally, lenders might let you borrow up to 80% of your home’s value, which means you’ll need more than 20% equity to benefit from a home equity loan. However, this can vary based on the lender you choose.
Say your home is worth $250,000, and you owe $150,000 on your mortgage loan. When you divide $150,000 by $250,000, you get 0.60 which represents a 60% LTV. If your lender approves borrowers up to 80% LTV, you may be able to borrow another 20% against your home’s value, or a total loan amount of $50,000. In total, you’ll owe $200,000, which equals 80% of your home’s $250,000 value.
What credit score do you need for a home equity loan?
Different lenders have different lending criteria, so ask any lender you’re considering what the minimum credit score requirements are before you apply. Many will list the minimum score you’ll need in their advertising or marketing materials.
Some lenders might even work with borrowers with poor credit, but they could require borrowers to have more home equity and less overall debt, while imposing higher interest rates. If you have questions about your eligibility, loan terms, or rates, consider reaching out to potential lenders directly.
How much cash out can you get when you refinance?
The amount you could cash out on a refinance typically depends on the value of your home. Although terms may vary among lenders, many may allow you to access up to 80% of your home’s value. The biggest exception to the 80% LTV rule is Veterans Affairs (VA) loans, which give you access to the full amount of your home’s equity.
Is a home equity line of credit (HELOC) better than a home equity loan?
The better option for you will depend on your situation. While HELOCs and home equity loans both let you borrow against your home’s equity, they function differently.
As its name suggests, a HELOC acts as a line of credit, giving you the flexibility to only borrow what you need and repay that amount over time. It can come in handy if you’re working on a home renovation and you’re aren’t sure of the exact cost. A home equity loan is typically a set loan amount that you repay over time.
The bottom line
Both cash-out mortgage refinance loans and home equity loans are strategic tools to tap into your home’s equity — and potentially get a lower interest rate in the process. Determining which of the two loan options is best for you depends on your financial profile and your objectives for the loan proceeds.
No matter which you choose, it’s wise to compare options from the best mortgage lenders and scrutinize offers for the best annual percentage rate (APR), repayment term, and applicable closing costs. Review the fine print and pay particular attention to the fees so you can accurately determine the actual costs of a home loan.
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