Cash-out Refinancing vs Home Equity Loans

Leveraging home equity — the difference between what you owe on a mortgage and what your home is worth — is a handy way to pay for home improvements, consolidate debt, finance the costs of education, pay medical bills, or handle a variety of other expenses. Many Americans are tapping into this spending power since the national home equity average reached a record high of $300,000 in 2022. 

Two of the most common ways to leverage home equity for cash are a cash-out refinance and a home equity loan. Each has advantages and disadvantages, so it’s essential to compare them and decide which is right for you.

What Is the Difference Between Refinancing and a Home Equity Loan?

The primary difference between a cash-out refinance and a home equity loan is how they affect your existing mortgage. A cash-out refinance pays off the original mortgage, and you start over with a new mortgage with a new term and rate. A home equity loan leaves the original mortgage intact, and you take out an additional loan against your equity, with its own term and interest rates.

To illustrate how they work differently, consider the example of a homeowner with a mortgage balance of $100,000 on a home worth $300,000. Most lending institutions will require the homeowner to leave 15–20% of their equity intact, so the actual amount available to be borrowed will be about $240,000, depending on the lender. In the case of a cash-out refinance, the homeowner borrows the $240,000 as a new mortgage, pays off the balance of $100,000, and is left with $140,000 of available cash. In the case of a home equity loan, the original mortgage stays as is, and the homeowner borrows the equity balance, $140,000, as a separate loan.

Additional differences between the two types of loans may include the following:

• A cash-out refinance generally has higher closing costs.
• A cash-out refinance generally has lower interest rates and is available as a fixed-rate or adjustable-rate loan.
• A cash-out refinance is paid out as a lump sum. Home equity loans are usually paid as a lump sum, but some lenders offer a line of credit called a HELOC.

How Does a Home Equity Loan Work?

As mentioned in the above scenario, if you choose a home equity loan, the original mortgage stays as is, and you can borrow a lump sum of about $140,000 (80% of the accrued equity minus the original mortgage balance) as a second loan with its own rates and term. 

Interest rates for home equity loans have been averaging around 7% for some time now, but individual lenders may offer incentives to improve rates. The term can be as little as five years but commonly ranges up to 30 years, depending on the amount and the lender. The longer the term is, the higher the interest rate will generally be. While there may be minimal closing costs, some lenders will waive the fees.

As an option, you can choose a line of credit over a lump-sum loan. This is known as a home equity line of credit (HELOC). During the draw period (usually ten years), you may only need to pay the interest on the borrowed amount, or you can choose to pay more to pay off some of the balance. Once the equity is used or the ten years is up, the line of credit ends, and the loan repayment term begins, typically for an additional 20 years.

Criteria for a Home Equity Loan

To qualify for a home equity loan, you’ll typically need to meet basic requirements, including:

• A credit score that satisfies your lender’s minimum requirement (generally around 620)
• A maximum loan-to-value ratio (LTV) of 80–85%, depending on the lender, meaning that 15–20% of home equity remains after accounting for all home loans.
• The ability to repay the loan at the agreed-upon terms
• A maximum debt-to-income (DTI) ratio — typically 43% — which totals your monthly debt payments and divides it by your total monthly income before taxes

How Does a Cash-Out Refinance Work?

If you opt for a cash-out refinance in the above scenario, you can typically borrow about $240,000 (80% of the total accrued home equity). This means you’ll be able to pay off the $100,000 balance on the current mortgage and receive a check for the remaining $140,000. You begin paying a new, larger mortgage at current interest rates and for a new term. Interest rates for refinancing currently range between 6% and 8% depending on the repayment term and the lender.

The process of qualifying for a cash-out refinance is similar to what you experience with a home equity loan. After selecting a lender and submitting an application, you’ll need to wait until they complete the underwriting process before you can qualify and receive payment. They’ll verify your income, appraise your property, and collect information on your debt, credit score, current assets, and other factors required by the lender. Once you are approved by underwriting, you will close on your new mortgage and can expect to receive your check funds three to five days later.

Criteria for a Cash-Out Refinance

To qualify for cash-out refinancing, you’ll typically need to meet basic requirements, including:

• A credit score that satisfies your lender’s minimum requirements, which may be lower than those required for home equity loans
• A maximum loan-to-value ratio (LTV) of 80-85%, depending on the lender, meaning that 15-20% of home equity remains after financing.
• The ability to repay the loan at the agreed-upon terms
• A maximum debt-to-income (DTI) ratio, usually 43%

Cash-Out Refinance vs. Home Equity Loan Pros and Cons

Since your choice will be based on factors such as current mortgage balance and terms, interest rates, accrued home equity, and more, it’s helpful to weigh the pros and cons of both loan types and see how they affect each of these variables. 

Advantages of a Home Equity Loan

A home equity loan, or second mortgage, can keep your monthly payments down while delivering a lump sum of cash for expenses. That’s because a home equity loan results in two monthly payments, and the second loan may be offered at better interest rates than a new mortgage for the total amount. Here are some other advantages to consider:

• Interest rates may be lower than your original mortgage, making the second mortgage a better option than a new mortgage.
• No origination fees mean little to no closing costs.
• There’s no mortgage insurance required.
• These generally have lower interest rates than a personal loan or credit card.
• Interest payments can be tax-deductible if the loan use qualifies.

Disadvantages of a Home Equity Loan

Home equity loans come with a few downsides, as well. When considering this strategy, factor in the following:

• Since the home is collateral, defaulting on the loan can mean you lose your home.
• If you sell your home, you’ll have to pay off the entire balance of the loan.
• Home equity loans require a good to excellent credit score.
• A lump-sum loan can mean a homeowner “over-borrows,” meaning you may end up paying interest on the money you didn’t need to borrow.

Advantages of a Cash-Out Refinance

A cash-out refinance results in a completely new mortgage. This can be a profitable financial strategy if you consider the following advantages:

• Borrowers with lower credit scores may be able to qualify.
• It comes with one monthly payment instead of multiple loans.
• Interest rates could be lower than your original mortgage.
• Interest rates are generally lower than personal loans and credit cards.
• A cash-out refinance may improve your credit score because you pay off your original mortgage in full, whereas a home equity loan means you take out an additional loan.

Disadvantages of a Cash-Out Refinance

As with any borrowing option, cash-out refinances have some downsides to consider, including;

• With rising interest rates, your new mortgage rate may be higher than your old one.
• Since it’s a new mortgage, you begin the payment term all over again.
• You could lose your home in foreclosure if you default on the new mortgage.
• Closing costs can be high.

Choosing Between Cash-Out Refinance or Home Equity Loans 

After reviewing the pros and cons, talk to your lender and consider some of the scenarios below as you choose the best financial strategy. 

You might choose cash-out refinancing in the following situations:

• Moderate credit scores: A borrower with a more moderate credit score may still be able to qualify for cash-out refinancing.
• Debt consolidation: If you want to consolidate debt and end up with a single monthly payment that is easy to manage, cash-out refinancing may be a good option. Consolidating high-interest debts, such as credit card bills, will allow you to pay off those debts and lower your interest.
• A low-rate market: If national interest rates decrease, it may be a good time to refinance and lower your total mortgage interest. Of course, you’ll begin a new term, so you’ll have to weigh this against the years left on your previous mortgage.

On the other hand, you might choose a home equity loan in the following situations:

• High accrued home equity: A borrower who has built up a large amount of home equity can use this to their advantage. If the amount of equity exceeds the balance left on the mortgage, you can even choose to pay off the original mortgage, have some cash left over, and pay a single loan payment.
• Lower interest rates: If a home equity loan is available at a lower interest rate than the fixed interest rate on your mortgage, it may be cheaper to pay two loans rather than refinancing your original mortgage.
• Shorter payment terms: While a new mortgage may take 15–30 years to pay, you can pay off a home equity loan in as little as five years. For some borrowers, the shorter term is more attractive.

Your lender can help you successfully weigh the pros and cons and select a cash-out refinance or a home equity loan. Armed with this information, you can choose the financial strategy that best fits your circumstances.