Cash-Out Refinance vs. Home Equity Loan: What's the Difference?

Cash-Out Refinance vs. Home Equity Loan: An Overview

A cash-out refinancing pays off your old mortgage in exchange for a new mortgage, ideally at a lower interest rate. A home equity loan gives you cash in exchange for the equity you've built up in your property, as a separate loan with separate payment dates.

Cash-Out Refinance

A cash-out refinance is a mortgage refinancing option in which an old mortgage is replaced with a new one with a larger amount than was owed on the previously existing loan, helping borrowers use their home mortgage to get some cash.

You usually pay a higher interest rate or more points on a cash-out refinance mortgage, compared to a rate-and-term refinance, in which a mortgage amount stays the same. 

A lender will determine how much cash you can receive with a cash-out refinance, based on bank standards, your property’s loan-to-value ratio, and your credit profile. A lender will also assess the previous loan terms, the balance needed to pay off the previous loan, and your credit profile.

The lender will then make an offer based on an underwriting analysis. The borrower gets a new loan that pays off their previous one and locks them into a new monthly installment plan for the future.

Pros and Cons

The primary advantage of a cash-out refinance is that the borrower can realize some of their property's value in cash.

With a standard refinance, the borrower would never see any cash in hand, just a decrease in their monthly payments. A cash-out refinance can possibly go as high as approximately 125% of the loan-to-value ratio.

This means the refinance pays off what they owe, and then the borrower may be eligible for up to 125% of their home’s value. The amount above and beyond the mortgage payoff is issued in cash just like a personal loan.

On the other hand, cash-out refinances have some drawbacks. Compared to rate-and-term refinancing, cash-out loans usually come with higher interest rates and other costs, such as points.

Cash-out loans are more complex than a rate-and-term and usually have higher underwriting standards. A high credit score and lower relative loan-to-value ratio can mitigate some concerns and help you get a more favorable deal.

Home Equity Loans

Home equity loans allow you to borrow against the equity you've built in your home; the difference between its current value and the mortgage balance due. Home equity loans tend to have lower interest rates than personal, unsecured loans because they're collateralized by your property, and that's the catch: The lender can come after your home if you default.

Home equity loans also come in two flavors: the traditional home equity loan, in which you borrow a lump sum, and the home equity line of credit (HELOC).

Second Mortgages

A traditional home equity loan is often referred to as a second mortgage. You have your primary mortgage, and now you're taking a second loan against the equity you've built in your property. The second loan is subordinate to the first—should you default, the second lender stands in line behind the first to collect any proceeds due to foreclosure.

Home equity loan interest rates are usually higher for this reason. The lender is taking a greater risk. HELOCs are sometimes referred to as second mortgages as well.

HELOCs

A HELOC is like a credit card that's tied to the equity in your home. For a set time period after you receive it, known as the draw period, you can generally borrow as little or as much of that credit line as you want, although some loans do require an initial withdrawal of a set minimum amount.

You may be required to pay a transaction fee each time you make a withdrawal or an inactivity fee if you don't use your credit line at any time during a predetermined period.

During the draw period, you pay only interest on what you've borrowed. When the draw period ends, so does your credit line. You start paying back the principal plus interest when the repayment period kicks in.

All home equity loans generally have a fixed interest rate, although some are adjustable, while HELOCs typically have adjustable interest rates.

The APR for a home equity line of credit is calculated based on the loan's interest rate, while the APR for a traditional home equity loan generally includes the costs of initiating the loan.

Pros and Cons

The primary advantage of a home equity loan is unlocking the cash value of your home's equity. You typically receive a lump sump, and the other advantage is that it can be used for any purpose, including renovations and improvements to your property that, in turn, can raise its value.

On the other hand, home equity loans come with risks that you should be aware of:

• Your home secures the loan, so your home is at risk if you fall behind on your loan repayments.
• With a traditional home equity loan, you have to borrow a set amount of money. If you don't end up needing the whole amount, you can be stuck paying interest on a portion of the loan you don't use. This is why HELOCs are a better option for homeowners who need to cover ongoing, unpredictable expenses.
• You can’t get a home equity loan with too much debt or poor credit. This bars some people from being able to access the equity in their homes.
  

Key Differences

There are several reasons why you might choose a cash-out refinance over a home equity loan.

In principle, a cash-out refinance gives you the quickest access to the money you've already invested in your property. With a cash-out refinance, you pay off your current mortgage and enter
into a new one. This keeps things simple and can release a great deal of cash very quickly—cash that can even help improve your property's value.

On the other hand, cash-out refinancing tends to be more expensive in terms of fees and percentage points than a home equity loan. You will also need to have a great credit score in order to be approved for a cash-out refinance because the underwriting standards are typically higher.

A home equity loan is easier to obtain for borrowers with a low credit score and can release just as much equity as a cash-out refinance. The cost of home equity loans tends to be lower than cash-out refinancing and can be far less complex.

Home equity loans also have drawbacks, though. With this type of loan, you are taking out a second mortgage in addition to your original one, meaning that you now have two liens on your property, which translates to having two separate creditors, each with a possible claim on your home. This can increase your risk level and is not recommended unless you are certain you can make your mortgage payments and home equity loan payments on time every month.

Utilizing the Money and Equity in Your Home

Your ability to borrow through either cash-out refinancing or a home equity loan depends on your credit score. If your score is lower than when you originally purchased your home, refinancing might not be in your best interest because this could quite possibly increase your interest rate.

Get your three credit scores from the trio of major credit bureaus before going through the process of applying for either of these loans. Talk with potential lenders about how your score might affect your interest rate if they're not all consistently over 740.

Taking out a home equity loan or a home equity line of credit demands that you submit various documents to prove that you qualify, and either loan can impose many of the same closing costs a mortgage does. These include attorney fees, a title search, and document preparation.

They also often include an appraisal to determine the market value of the property, an application fee for processing the loan, points—one point is equal to 1% of the loan—and an annual maintenance fee. Sometimes lenders will waive these, however, so be sure to ask about them.

The Bottom Line

Cash-out refinancing and home equity loans can benefit homeowners who want to turn the equity in their homes into cash. To decide which is the best move for you, consider how much equity you have available, what you will be using the money for, and how long you plan to stay in your home.