The Big Comparison: Cash Out Refinance Vs Home Equity Loan
If you're in need of extra cash (for whatever reason), then instead of applying for a personal loan, you might want to consider using your home as collateral for either a home equity loan or a cash-out refinance. Both of these can be effective ways to obtain cash— especially if you need a significant amount of it. However, there are a few things you'll want to consider to determine whether a cash-out refinance or a home equity loan is best for you.
A Brief Intro to Home Equity Loans
Home equity loans are a good option if you have equity built up in your home. Essentially, you're borrowing money against that equity. But if you just started paying down the mortgage on your home, then you won't have a lot of equity available and you may not be able to qualify for a home equity loan. Generally speaking, you can borrow up to 90 percent of the value of the equity you have in your home.
There are two ways in which home equity loans work. The traditional way would be to get a direct cash loan against your home's equity which you will then have to pay off with interest on a monthly basis. The second way is through a line of credit, which is known as a HELOC loan. With a HELOC loan, you are given a line of credit against the equity of your home. You can then withdraw from that line of credit for a specific amount of time. You'll only owe money and interest on the amount that you withdraw from this line of credit.
A Brief Intro to Cash-Out Refinance Loan
A cash-out refinance is a form of mortgage refinancing. Essentially, you refinance your mortgage but do so at a greater amount than what the balance on your current mortgage is. The difference between the two is then provided to you in cash. You can use the cash however you want -- the rest of the refinance loan will be used to pay off your initial mortgage loan. You'll then simply make payments every month until the refinance mortgage is paid off.
The main difference between the two types of loans is that a cash-out refinance loan is essentially a mortgage that replaces your initial home loan, whereas a home equity loan is an additional loan that you'll have to pay on top of your existing mortgage. Of course, there are other differences to consider as well, including the interest rate and the payment options.
Generally speaking, cash-out refinance mortgages come with lower interest rates. They are a particularly good option if the current interest rates are lower than the interest rates on your existing mortgage. One of the reasons interest rates are lower than those on a home equity loan is because there's less of a risk for lenders. If you default, the lender will be able to foreclose on your house and use the proceeds towards paying off the remaining balance on the refinance mortgage. They don't have to worry about the initial home loan since the cash out refinance mortgage paid it off.
Interest rates on home equity loans are typically higher because the risk for lenders is greater. If the borrower defaults, the balance on the mortgage must be paid off first, leaving the lender of the home equity loan potentially at a loss. Additionally, you can choose from fixed and variable rates when taking out a cash-out refinance loan, whereas home equity loans are only available with fixed rates. However, HELOC loans are only available with variable rates.
Both cash-out refinance loans and home equity loans can be provided directly in cash. The drawback to this payment option is that you will begin paying interest on the total loan amount right away. However, because a cash-out refinance is replacing your initial mortgage, it may not affect your monthly payments a great deal (unless you change the terms drastically, such as going from a 30-year term to a 15-year term). With a home equity loan, you'll be making payments towards your loan's balance in addition to your current mortgage payments.
With a HELOC loan, you won't pay any interest until you withdraw money from your line of credit -- and you'll only pay interest on the amount that you withdraw. Additionally, whatever amount you repay goes back into your line of credit. For example, if you withdraw $5,000 from a $10,000 line of credit and you repay $3,000 after two months, your line of credit will be $8,000.
Factors To Think About
Besides the difference in interest rates and payment options, there are a few other factors to take into consideration before deciding which type of loan best suits your needs, including these:
The Amount You Need
If you only need a small amount or you need access to funds over time, a HELOC might be your best option since you'll only pay interest on what you withdraw and you'll have access to your line of credit for some time. If you need the money right away but only need a small amount, then a home equity loan might be the better option, especially if refinancing your mortgage won't result in terms that are much more favorable than what you have. This is because if you get a cash-out refinance loan, you'll usually have to pay for closing costs up front (which can be quite expensive), whereas with a home equity loan, you can roll the closing costs into the loan.
Both home equity loans and cash-out refinance loans are suitable if you need large amounts of cash upfront. It comes down to whether it's worth replacing your current mortgage and what you can afford to pay on a monthly basis -- if you're on a strict monthly budget, you may not be able to take on the additional payments required by a home equity loan.
Amount Of Your Equity
Both cash-out refinance loans and home equity loans require that you have at least 20 percent equity in your home. This means that both types of loans will allow you to borrow up to 80 percent of the home's value. However, with a HELOC loan, you can borrow up to 85 percent of your home's value depending on how creditworthy you're deemed to be.
Home equity loans can be paid back in 5, 10, and 15-year periods, whereas cash-out refinance loans can have terms up to 30 years (like a standard mortgage). Generally speaking, it's better to pay off a home equity loan as quickly as you can since the interest is higher. However, this can be difficult depending on your means since you'll be paying off your mortgage at the same time as you're paying off your home equity loan, whereas your cash-out refinance loan simply replaces your existing mortgage.
If you get a HELOC loan, you can get a 20-year term with a 10-year draw period. You'll only make payments based on how much you withdraw from your line of credit.
Amount You Are Willing To Risk
Just because you have a lot of equity in your home doesn't mean you should borrow as much as you can. You're putting up your home as collateral, after all, which means you're taking a risk. If things are tight financially, a home equity loan might be a bigger risk since it will increase the amount you have to pay every month, whereas with a cash-out refinance loan, it could potentially reduce the amount you have to pay monthly depending on the terms you choose.
Scenarios in Which a Home Equity Loan May be Suitable
If you're almost done paying your mortgage off, then refinancing it may not make sense. In such a case, a home equity loan is a better option. Home equity loans can be used for anything, but they are particularly popular for home improvements, which can help improve your home's value, thereby increasing the equity you have in it. HELOC loans are also quite useful if you don't need all the money at once. For example, you may want to do routine maintenance, repair, and renovation work on rental properties that you own or pay for college tuition.
Scenarios in Which a Cash Out Refinance Loan May be Suitable
Cash out refinance loans only make sense if the terms are better than those on your current mortgage. If the interest rate will be higher, then a cash-out refinance may not be the best idea. However, if you can lock in a lower rate and you still have a long way to go before you pay off your mortgage, then a cash-out refinance might be able to help you save money on interest long term in addition to getting you the money you need. A cash-out refinance can be even more beneficial if you're using it to pay down debts, reducing the interest you pay on those debts even more.
Both Of These Options Have Their Pros And Cons
If you need to borrow money, then cash-out refinance loans and home equity loans will usually provide you with more favorable terms than personal loans will. Since both of these loans will require you to put your house up as collateral, it's important that you consider the pros and cons of both before deciding which one best suits your personal needs.
Still undecided which loan to take? Talk to one of our trusted advisers now!