Cash-Out Refinancing vs. Home Equity Loan: How to Choose

If you’re a homeowner with a good amount of equity in your property, then a cash-out refinance, home equity loan, or home equity line of credit could offer money when you need it.

Whether you’re facing high medical bills or just looking to cover a kitchen remodel, any of these three financing options can give you the cash you need to pay the bills by tapping your home equity.

Check your home equity

Most lenders require you to have at least 20% equity — or a loan-to-value ratio (LTV) of 80% or less — to be eligible for cash-out refinancing or a home equity loan. Some lenders may lend up to 85% of your home value meaning you only need 15% equity. Check with your lender beforehand to determine how much equity you need.

You can estimate your current equity by taking the appraised value of your home and subtracting it from your mortgage balance.

Here’s how it works: If your home value is $300,000 and your current mortgage balance is $225,000, you have $75,000 (25%) in home equity.

$300,000 - $225,000 = $75,000, or 25% equity

You can increase your equity by continuing to pay down your mortgage principal. Equity also increases over time as your home value rises.

How a cash-out refinance works

A cash-out refinance is a method of replacing your existing mortgage loan. It’s a type of mortgage refinance where you apply for a new mortgage that’s larger than your current loan balance.

Once approved, the new loan pays off your old mortgage and any closing costs, and you’ll receive the difference between the two loans in cash. You’ll also get a new monthly mortgage payment based on your new loan terms and balance.

Here’s how it works: Let’s say you have a current mortgage balance of $100,000. You apply for a cash-out refinance worth $175,000. When your loan closes, you’ll receive a payment of $75,000 — the difference between the two balances. Your monthly payment will also change, though you’ll still only have one payment per month.

There are several requirements that can affect your borrowing amount and interest rate:

• Credit score: You’ll need an excellent credit score to qualify for the lowest rates. Aim for a credit score of at least 750. However, you can still get a competitive rate with a lower score.
• Stable income: Plan on providing a recent pay stub and your two most recent tax returns to verify your employment and income history.
• Debt-to-income ratio: Private lenders typically require a debt-to-income ratio (DTI) below 43% to show you can afford your new monthly payment.
• Home appraisal: Your lender will require a new home appraisal to calculate your property value, current equity, and your maximum borrowing power.

Learn More: The Pros and Cons of Cash-Out Refinancing

How a home equity loan works

Home equity loans can be an excellent option when you want to access your equity but don’t want to refinance your mortgage. You can use the funds from a home equity loan to make home improvements or put them toward non-home expenses, like debt consolidation or college tuition.

Since home equity loans are a type of second mortgage, you won’t refinance your existing mortgage. Instead, repayment works much like your original mortgage. You’ll make monthly payments toward your home equity loan over a fixed term (usually five to 30 years) until the loan is paid off. If you fall behind on your payments, your lender can foreclose on the home.

Here are some of the main benefits of a home equity loan:

• Fixed monthly payments and interest rate
• No need to refinance your first mortgage
• Lenders may waive or reduce closing costs

In addition, your interest payments might be tax-deductible. You’ll just need to make sure you’re using the funds for qualifying repairs and capital improvements on the home securing the loan.

How a HELOC works

A home equity line of credit (HELOC) is another type of second mortgage. This loan generally makes sense if you want to borrow smaller sums over a longer period, or if you want money available to borrow just in case.

With a HELOC, you’re given a line of credit with a maximum borrowing limit, similar to a credit card. You can withdraw what you need during the loan’s draw period (usually 10 years), and you’ll only pay interest on what you borrow.

In many cases, lenders will only require you to pay interest during the draw period, however, you’re free to make principal payments during this time as well.

Here are some of the main benefits of a HELOC:

• Ability to make withdrawals as needed during the draw period
• Interest-only payments are often allowed during the draw period
• Only pay interest on what you borrow

Once the draw period ends, you cannot make any additional withdrawals and must repay both interest and principal. You might have a draw period of 10 years followed by a repayment period of 20 years, but shorter terms are available, too.

Unlike home equity loans, HELOCs generally have variable interest rates. However, some lenders might offer fixed-rate HELOCs.

Home equity loan and HELOC requirements

The requirements for a home equity loan and HELOC are similar to a cash-out refinance:

• A minimum credit score of 620 for conventional lenders
• Stable income and employment history
• Debt-to-income ratio below 43%
• At least 20% equity

One difference to a cash-out refinance is that the lender may recommend a desktop appraisal (i.e., an appraisal that’s performed using tax records and information from a multiple listing service) instead of an in-person appraisal.

As a result, the appraisal process can be quicker and cheaper for both a home equity loan and HELOC.

How cash-out refinancing, home equity loans, and HELOCs are similar

The key similarities between cash-out refinance and home equity loans are:

• Immediately access home equity: You can get your entire borrowing amount immediately after closing — not in installments or over time. A HELOC also gives you the flexibility of making future withdrawals if you don’t need all of the funds upfront. Each loan allows you to borrow up to 80% of your equity with most lenders.
• Use money for any purpose: It’s possible to use your funds for home improvements, tuition, medical bills, high-interest debt consolidation, and many other costs.
• Option to deduct your interest payments: To do so, the itemized deductions on your tax returns will need to exceed the standard deduction, and you must use the loan proceeds to buy, build, or improve your home.
• Similar borrowing requirements: Your lender’s credit, income, debt, and equity requirements are similar for each loan. You’ll generally need to have 20% equity in your home plus a DTI of 43% or less to qualify for these loans.

Don’t Miss: Cash-Out Refinance Tax Implications

How cash-out refinancing, home equity loans, and HELOCs are different

The major differences between the three loans are:

• Replace your existing loan: A cash-out refinance replaces your existing loan, meaning you’ll only have one monthly payment and a new interest rate and APR for your entire mortgage balance. Meanwhile, home equity loans and HELOCs add a separate payment to your monthly bills.
• Adjustable rates: Home equity loans have a fixed rate but HELOCs generally come with a variable rate. A cash-out refinance may have either. With an adjustable-rate loan, your rate and payment may rise over time.
• Potentially lower interest rates: Cash-out refinances may offer lower interest rates than home equity loans. But while home equity loans are riskier for lenders, they may come with more favorable rates than other viable options, like credit cards and personal loans.
• No closing costs on home equity loans: Many lenders offer to waive the closing costs on home equity loans and HELOCs, but not for cash-out refinances. Your cash-out refinance fees can also be higher as your new loan is for a higher amount.

Find Out: Home Equity Loan With Bad Credit: Can It Be Done?

How to choose the right home equity loan

The right choice depends on your credit score and financial profile, how you plan to use the money, and how your existing mortgage rate compares to current mortgage rates.

When a cash-out refinance makes sense

A cash-out refinance generally makes sense when market interest rates are lower than the rate on your existing home loan. By qualifying for a lower rate for your entire balance, your monthly payment can be lower than your existing payment.

This loan can also be the best option if you want to continue only making one monthly payment or you want to modify your repayment period.

A cash-out refi can also be a good move if:

• You can find a loan with low closing costs
• Your credit or financial profile isn’t good enough to qualify for a home equity loan
• You are consolidating debt and want a low interest rate
• You won’t borrow too much and increase your risk of foreclosure

Learn More: No-Closing-Cost Refinance: Will It Save You Money?

When a home equity loan makes sense

A home equity loan generally makes sense if you know you can pay off the loan quickly. Since these loans come with higher interest costs, putting yourself on an accelerated repayment schedule can help minimize how much you’ll pay to borrow the money.

This loan can be a good option if you don’t want to refinance your existing mortgage. Your borrowing costs might be lower than the closing costs on a cash-out refinance as well.

A home equity loan can also be a good idea when:

• You can comfortably handle an additional monthly payment
• Market interest rates are higher than your current mortgage rate (and you don’t want to lose that rate by refinancing)
• You plan to use the money toward home improvements and it makes sense to itemize your tax deductions
• You want the security of a fixed interest rate
• You don’t need to make additional withdrawals

See: Should You Get a Home Equity Loan for Debt Consolidation?

When a HELOC makes sense

A HELOC generally makes sense if you want to borrow smaller sums over a longer period, or if you want money available to borrow just in case.

Making principal and interest payments during the interest-only draw period (when you’re not required to repay principal) can minimize how much you’ll pay to borrow over the life of the loan.

Amy Fontinelle and Aly J. Yale contributed to the reporting for this article.