Cash out refinance vs Home equity loan

Are you thinking about refinancing your home? Maybe you're considering a loan to pay off debt or renovate. A cash out refinance can allow you to do both, while a home equity loan might be a better choice if you want to access cash without changing your existing mortgage. Here are some details to consider before picking the option that works best for you.

Key differences: Cash out refinance vs home equity loan

Here are the main components of a cash out refinance:

• It may allow you to tap into the equity you've built up in your home. 
• You replace your existing mortgage with a new one for a higher amount than you currently owe. You receive the difference in cash.
• You could use the extra cash for various purposes, such as home improvement or debt consolidation.
• By replacing your existing mortgage with a new one, you may benefit from a lower interest rate, more favorable loan terms, or both. 

In comparison, here are the main components of a home equity loan:

• You could take out a second loan against the equity you've built in your home, typically at a fixed rate, without affecting your existing mortgage.
• The loan amount is yours to use in almost any way you choose.
• It won't impact the repayment term of your existing mortgage. You'll make two monthly payments — one for your primary mortgage and one for the new home equity loan.

What is a cash out refinance?

A cash out refinance is a loan that refinances your current mortgage into a larger mortgage, allowing you to take the difference in cash.

Assuming you have an adequate amount of equity in your home, a cash out refinance may make it possible for you to:

1. Obtain a new mortgage in the amount of your existing mortgage plus the additional amount you want to borrow. Your new mortgage may have a potentially new rate, terms, and/or repayment schedule.
2. Pay off your existing mortgage.
3. Receive the additional amount in a lump sum.

With a cash out refinance, you may be able to choose between a fixed or adjustable interest rate.

What is a home equity loan?

Home equity loans may suit borrowers who have a substantial amount of equity available to them. Equity is the difference between the current market value of your home and the amount you still owe on your mortgage.

Usually, the amount you may be able to borrow is determined by factors such as your credit score and combined loan-to-value (CLTV) ratio. Your CLTV is your desired home equity loan amount plus your existing mortgage balance, divided by your home's value. When you take out a second mortgage like a home equity loan, your original mortgage remains unchanged, but you will have two payments.

READ MORE: Is home equity loan interest tax deductible?

Which is the best: A cash out refinance or home equity loan?

When it comes to making big financial decisions, it's always a good idea to ask yourself a bunch of questions before diving in headfirst. Deciding between a cash out refinance and a home equity loan is no exception.

Let's walk through some important questions that may help you choose between a cash out refinance and a home equity loan:

1. What’s my primary goal? Are you looking to lower your monthly payments, tap into your home equity for a specific purpose, or consolidate high-interest debt? Understanding your primary goal may help determine which option best fits your needs.
2. Am I comfortable with potentially resetting my mortgage term? With a cash out refinance, you'll be replacing your current mortgage with a new one, which may mean adjusting your repayment term. Consider whether you're comfortable resetting the clock on your mortgage and extending the repayment timeline.
3. Do I want a fixed rate on my mortgage? Cash-out refinances may have interest rates that are fixed or adjustable, while home equity loans typically come with fixed interest rates. 

The best option for you depends on your unique financial situation and personal goals.

Other things to consider

There are other factors to consider before applying for a cash out refinance or a home equity loan:

• How much equity you have in your home: Take a moment to assess the amount of equity you've built up in your home. Both a cash out refinance and a home equity loan require you to borrow against your equity.
• Closing costs: Loans of all types may come with closing costs, such as fees associated with loan processing. Closing costs may vary between different lenders.
• Interest rates: Evaluate whether rates are low or high at the time you're considering a cash out refinance or a home equity loan. 
• Increased monthly payments: Both cash out refinances and home equity loans may result in more money owed every month compared to your existing mortgage.
• Tax implications/benefits: Consult with a tax professional to find out the potential tax implications and benefits of a cash out refinance or a home equity loan. The home mortgage interest deduction may let you deduct all or some of the interest you pay on either of these loans from your taxable income. According to the IRS, you must use the borrowed funds to "buy, build, or substantially improve" the property that secured the loan to be eligible for this deduction. 
• How long you plan to stay in your home: If you're thinking you might sell your home in the near future, consider the potential impact of either option on your selling plans.
• Comfortable managing your new debt: Assess your overall financial situation and ensure that taking on additional debt through a cash out refinance or a home equity loan won't strain your budget or put you at unnecessary risk.

Closing thoughts: Cash out refinance vs home equity loan