Cash out refinance vs Home equity loan

Are you thinking about refinancing your home? Or maybe you’re considering taking out a loan so that you can pay off debt or renovate your home. A cash out refinance can give you an opportunity to do both with a single loan, but a home equity loan might be a better option if you’re happy with your current mortgage.  Both options may be a good decision for current homeowners, but there are some details you will want to consider before picking the one that works best for you.

Key differences: Cash out refinance vs Home equity loan

The primary difference between a cash out refinance loan and other home equity loan options is that a cash out refinance converts one mortgage into a separate larger one. Other home equity loan product options typically create a second mortgage on your home. With a traditional home equity loan, you take on a second mortgage at a fixed rate with typically up to 30 years for repayment.

Here are the main components of a cash out refinance:

• You replace your existing mortgage with a new one for a higher amount, allowing you to receive the difference in cash.
• Typically offers a lower interest rate compared to home equity loans because it’s a primary mortgage.
• You can potentially extend the repayment term of your mortgage with a refinance to lower your monthly payments.
• Your mortgage balance increases, and you need to go through the refinancing process.
• You can use the extra cash for various purposes, such as home improvement or debt consolidation.

In comparison, here are several highlights of a home equity loan:

• You borrow a separate loan against the equity you have built in your home, without affecting your existing mortgage.
• Generally has a higher interest rate than a cash out refinance because it’s considered a second mortgage.
• It won’t impact the repayment term of your existing mortgage, and you will need to make two monthly mortgage payments – one for your primary mortgage and one for the new home equity loan.
• You have an additional loan on top of your mortgage without refinancing.
• The loan amount is yours to use in almost any way you choose.

What is a cash out refinance?

A cash out refinance is a loan that refinances your first mortgage into a larger mortgage which allows you to tap into your equity and take the difference in cash.

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

1. Pay off your existing mortgage.
2. Negotiate a new term, rate, and repayment schedule for your consolidated loan amount.
3. Obtain a new mortgage in the amount of your existing mortgage, plus the additional amount you want to borrow.
4. Receive the additional amount in a lump sum.

When you elect to use a cash out refinance loan and access your home equity, you enter into a whole new loan agreement. This means the terms, rate, and repayment plan for your new mortgage will be different.

Generally, cash out refinances are like purchase mortgages and offer up to 30 years for repayment. You may be able to choose between a fixed or adjustable interest rate. You might even be able to take advantage of potential tax savings depending upon how you are using the “cash out” portion of your loan that comes from your equity. Consult a tax advisor for information about your eligibility for this deduction.

READ MORE: Is home equity loan interest tax deductible?

What is a home equity loan?

Home equity loans best suit borrowers who have a substantial amount of equity available to them. You can determine the total amount of equity in your home by subtracting all debts secured by your house from the current fair market value of your home. The amount left over is the total equity, or value of ownership, of your house.

Usually, the amount you can borrow is determined by your credit 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 add a second mortgage to your home, your original mortgage remains unchanged, but you will have two mortgage payments.

Which is the best: 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 decide what works best for your financial future:

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 will help you determine which option aligns best with your needs.
2. How much equity do I have in my home? Take a moment to assess the amount of equity you’ve built up in your home. This will influence the loan options available to you and the potential funds you might access.
3. What’s the current interest rate environment? Interest rates can fluctuate, so it’s essential to evaluate whether rates are low or high at the time you’re considering a cash out refinance or a home equity loan. Lower rates may lead to significant savings over the long term.
4. 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 means adjusting your repayment term. Consider whether you’re comfortable resetting the clock on your mortgage and extending the repayment timeline.
5. Do I want a fixed rate on my mortgage? Both cash out refinances and home equity loans typically come with fixed interest rates, but there may be situations in which a homeowner is interested in a variable rate and should explore other options.
6. How much will I need to pay in closing costs? Mortgages of all types may come with closing costs, which include fees associated with the loan process. It’s important to factor in these costs while evaluating financial benefits. These costs will vary between different lenders.
7. Can I handle a higher monthly payment? Consider whether you’re financially prepared to take on increased monthly payments, since both cash out refinancing and home equity loans may result in higher obligations compared to your existing mortgage.
8. What are the potential tax implications? Consult with a tax professional to determine the potential tax implications and benefits of a cash out refinance or home equity loan. Depending on your circumstances, you may be eligible for mortgage interest deductions.
9. How long do I plan to stay in my 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. Analyze the timeline and evaluate if the benefits can outweigh any potential drawbacks.
10. Can I comfortably manage the additional 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.

These questions are designed to help guide your decision-making process, but they may not cover all personal circumstances. The best option for you will rely on your unique financial situation and your personal goals.