Finding the funds can be a challenge if you’re facing a major expense such as home renovations, paying off debts, or contributing to your children’s tuition. Unfortunately, recent events in the global economy may have caused you to dip into your savings, which can make it even more difficult to get your hands on extra cash when you need it.
However, if you’re a homeowner, you may be able to access some of the funds you have already paid into your property (known as your equity) by taking out a home equity loan or cash-out refinance mortgage .
We’ve put together a simple guide comparing a home equity loan vs cash-out refinance and explaining these two loan types' key features, differences, and similarities.
Often referred to as a second mortgage, a home equity loan enables you to borrow against the difference in your home’s market value and the balance due on your mortgage. As these loans use your property as collateral, they often come with lower interest rates than other forms of borrowing, such as credit cards or unsecured personal loans.
Home equity loans fall into two categories: fixed-rate loans and home equity lines of credit (HELOCs).
With this type of loan, you can apply for the amount you need to borrow, and, if approved, you'll receive the entire amount upfront as a lump sum. As these loans come with a fixed rate of interest, you’ll know exactly how much you’ll be repaying each month.
If you take out a HELOC, your lender will provide you with a certain amount of credit over a set period of time (known as your loan term). Unlike a fixed-rate loan, a HELOC is a revolving line of credit, which means it has some similarities to a credit card. As with a credit card, you won’t receive the entire amount of your HELOC as a single lump sum, but you can make withdrawals as and when needed.
Unlike fixed-rate loans, HELOCs usually come with variable interest rates. This means the amount of your monthly repayments can vary, which may not be ideal for those on a fixed income.
While a HELOC can provide you with more flexibility than a fixed-rate loan, there can also be a temptation to dip into your unused credit and, as a result, find yourself deeper in debt.
Before taking out a home equity loan, you should be aware that most providers restrict the amount you can borrow to between 80% and 85% of your home’s appraised value.
Likewise, a home equity loan may not be suitable if you need to borrow a relatively small sum. Although every lender is different, many companies will not enable you to borrow less than $35,000 as a home equity loan.
If you take out a home equity loan, you will also likely need to pay closing costs relating to your first mortgage, including processing fees, appraising fees, and origination fees.
A cash-out refinance, also referred to as a cash-out refi, involves replacing your old mortgage with a new larger loan. Under this model, you’ll receive the difference between your old mortgage amount and your new loan as a cash lump sum during closing.
The remainder of the funds from the new mortgage will go towards paying off the original loan. In essence, this means that you will now owe more under your new mortgage and are using your home as a means of accessing additional cash.
Imagine your home is worth $400,000, and you owe $200,000 on your current mortgage. As most lenders require you to leave at least 20% of the equity in your home (which is $80,000 in this example), you could refinance your home with a loan amount of $320,000. In this scenario, you would receive $120,000 (i.e. the new loan amount minus the amount you still owe on your old mortgage).
Although you can usually take out up to 80% of the value of your home under a cash-out refinance, a lender will look at a range of factors, such as your credit history, to determine the amount you can borrow.
In most cases, you’ll have access to these funds within three business days of closing, although you will need to pay closing costs and fees associated with taking out your new mortgage.
When you take a cash-out refinance loan, you’ll be replacing your old mortgage with a new loan. In contrast, a home equity loan is another loan that you will need to make payments on, in addition to your original mortgage.
A cash-out refinance deal will typically offer more competitive interest rates than a home equity loan. Because a cash-out refinance loan is considered a first mortgage, the lender would receive priority payment if you were to go bankrupt. This means that these loans are generally less risky for a mortgage provider.
While it is important to understand the differences between these two loans, they also include several key similarities.
With both types of loans, you will not normally be able to tap into the total amount of the equity you have built up in your property.
Likewise, neither type of deal includes any restrictions on how you use the money that you have borrowed, which means you can put it towards any purpose that suits your personal finances— whether that’s consolidating old debts or starting a new business.
However, perhaps the most crucial similarity is that both loan types use your property as collateral, and you risk losing your home if you fail to keep up on your repayments.
When you’re borrowing against the value of your property, you’ll almost always need a new home appraisal. This is because the amount you can take out as a loan is determined by the current market value of your home and not its value at the time of your initial purchase.
If you bought your home several years (or even decades) ago, it’s likely that its value will have changed significantly. While we all hope our homes will go up in value, there is also a chance that the property could now be worth less than when you bought it.
Whichever type of loan you choose, you will typically need to provide documents such as:
As with any major financial decision, it’s essential that you receive quotes from as wide a range of companies as possible when you’re looking for a home equity or cash-out refinance mortgage.
While it may be tempting to stick with your current bank or loan provider, this may not necessarily guarantee you the best deal. You can find a range of deals by visiting an online price comparison site. If you have complex financial circumstances, you should discuss your needs with a mortgage broker.
Although taking out a home equity loan may be a shrewd choice for the 44.9% of Americans who are now considered equity rich (ATTOM), these products will not suit everyone’s finances.
If you’ve done your math and decided that neither a home equity loan nor cash-out refinance is suitable for you, there are alternative ways to borrow money. These include:
So, HELOC vs cash-out refi? Which, if either, is right for you? The answer will depend on your personal finances. But once you understand the advantages and downsides of both loan types, you’ll be in a stronger position to decide whether tapping into your home’s equity is the best way to take control of your finances.
One golden rule: if you’re uncertain about anything relating to a potential home loan, it’s essential you contact the lender to ask for clarification. Remember, any respectable lender will want to ensure you understand all the fine print.