Find out the difference between Cash Out Refinance and Home Equity Loans.
Cash out refinancing and home equity loans both revolve around you using your home as collateral in order to borrow money. If you are looking to figure out which option is better for you, it would depend on how much equity you currently have in the home, your current mortgage, your creditworthiness and the lenders’ offers.
Cash Out Refinance Meaning
According to the cash out refinance definition, it is a mortgage loan through which you can borrow some of your home equity by replacing your current mortgage with a new one. The new loan will be for more than the balance of your previous loan and the difference will be given to you in cash.
A cash out refinance can be an entirely new first mortgage that has cash back when the loan closes. This option is attractive for homeowners who want to refinance and take out some cash at the same time.
How Does Cash Out Refinancing Works?
The process of cash out refinancing is similar to the process of taking out your first mortgage. It may require an appraisal so your home’s value can be determined. Generally, you are allowed to borrow up to about 80 to 85 percent of the home’s value.
However, if the loan-to-value (LTV) ratio is above 80 percent, you may have to pay for private mortgage insurance on your new mortgage.
For example, if your home was appraised for $300,000, 80 percent of that value will be $240,000. Let’s suppose your current mortgage balance is $200,000. You may still be able to get a cash out refinance for $240,000 while receiving $40,000 in cash.
The loan will then be repaid based on the terms of your new mortgage. Just like a purchase mortgage, you will be allowed to choose between a fixed and variable rate. You can also choose 15 to 30 year terms on your refinance.
Ideally, you can end up saving money by qualifying for a lower interest rate. However, closing costs can offset some of the money you have saved.
How Does a Home Equity Loan Work?
A home equity loan is a type of second mortgage that you take out in addition to your primary mortgage. There is also a home equity line of credit (HELOCs) which is quite similar to a home equity loan except they give you a line of credit that can be borrowed against instead of the entire loan amount upfront.
Some lenders allow borrowers to borrow up to 85 to 90 percent of your home’s value with a home equity loan. This is based on the combined loan-to-value ratio (CLTV) which takes the home equity loan into account along with the balance of your first mortgage.
Keeping the figures above in mind, 90 percent of $300,000, which is your home worth, is $270,000. If the balance of your current mortgage is $200,000, you can get a home equity loan for $70,000.
If your lender does not require an in-person appraisal, getting a home equity loan may be quicker for you. You would also not have to worry about the closing costs on the loan as some lenders tend to cover those themselves. Home equity loans can also have fixed rates and shorter terms than primary mortgages do. However, you will have to make monthly payments on both your original mortgage and home equity loan. If you fall behind on any one of these loans due to any reason, your lender will have the authority to foreclose on your home.
Home Equity Line of Credit
A HELOC is a credit line that is secured by your home. Most HELOCs tend to have an adjustable rate along with interest-only payments for a specific time period and a 10-year “draw” period during which the borrower can access the funds.
After the draw period is over, the outstanding balance has to be repaid usually over a 15 or 20 year term.
Homeowners that have adequate enough who do not tip the debt overload scale can qualify for this type of loan. They can usually find financing of this kind for 20 percent of combined loan to value or even 85 percent or 90 percent combined loan to value.
Things to Consider Before Picking a Home Equity Loan?
Before picking a home equity loan, you should know that the right kind of home equity loan depends on your needs and financial situation. Here are a few factors you need to take into account when comparing different financial products:
1. Check fees and interest rates.
When you are comparing lenders and products, you should take into account both closing costs and interest rates. Fees can be higher for a cash out refinance than it would be for a HELOC but the interest rate will probably be lower.
2. What is your current interest rate?
Depending on repayment terms, loan balances and interest rates, your new monthly payment can be higher or lower than your current payment.
For example, if you have an existing mortgage with a very low rate and you go for a cash out refinance, there is a chance you can find yourself paying a higher rate on your entire loan instead of just the cash out portion.
3. Beware of market volatility.
When there is a financial crisis, like the coronavirus pandemic, it is likely for home equity products to take a hit. Lower loan amounts, tighter eligibility requirements and even limited offerings can all be tactics implemented by lenders to protect themselves in case of an economic downturn. Home equity loans and HELOCs may even stop being offered by lenders in time of financial crisis so that lenders can respond to market volatility if you are considering tapping your home equity.
Which is Better: Cash Out Refinance or Home Equity Loan?
Both cash out refinancing and home equity loans can help you turn your equity into money that you are able to use today. These forms of financing are used by many people for home repairs, maintenance or improvements or for other major expenses like college expenses or a wedding.
Here is a general overview of differences between home equity loans and cash out refinance mortgages.
|Cash Out Refinance||Home Equity Loan|
|Interest Rates||Fixed and variable||Usually fixed|
|Repayment Term||15 to 30 years||5 to 30 years|
|Replaces Current Mortgage||Yes||No|
|Tax Deductible||If the money is used to improve the home||If the money is used to improve the home|
|Closing Costs||Yes||Lenders may cover these costs|
Home equity loans usually have higher interest rates than cash out refinancing loans do. Which means if you fall behind on payments, the lender will only be paid after the primary mortgage holder gets what is owed.
This higher interest can be somewhat offset by no or low closing costs. But you should always read the fine print on your loan. Lenders might cover the closing costs but they might also require you to repay some amount if you end up paying off your home equity loan early.
Which Should You Use?
Deciding which one between the two is better for you can vary depending on how much equity you have built in your home, lender’s current offers and your creditworthiness.
If you are using a cash out refinance and it is increasing your mortgage rate or adding private mortgage insurance then making a higher monthly payment and long-term costs of the loan may not be worth it.
However, a cash out refinance might be the ideal option for you to borrow money if you can lock in a lower mortgage rate while getting some cash out of your home.
A home equity loan can be the better option if you are looking to borrow a large portion of your home’s value or if you cannot seem to find a lower rate when refinancing. The monthly payments can be higher if you choose a shorter term loan. However, that would also mean that you pay less interest overall.
You can use a cash out refinance calculator or a home equity loan calculator to figure out how much it is going to cost you overall.
How a Cash Out Refinance and Home Equity Loan Affects Credit
A cash out refinance and a home equity loan can have a similar impact on your credit scores. The main difference would be that a cash out refinance will end up paying off and closing your original mortgage whereas a home equity loan will only be an additional loan.
However, the paid off loan can end up on your credit report for up to 10 years and will continue to impact your scores during that period.
Home equity loans and cash out refinancing both involve you taking out a new installment loan. In either case, lenders can review your credit reports through a hard inquiry. Moreover, when a loan is added to your credit reports, the average age of accounts on your reports can decrease leading to a high balance on your loans relative to their original loan amount. These factors can end up hurting your scores only a little as they are minor factors.
Once you start repaying your new loan, the on-time payments can be reported to the credit bureaus and help your credit. If you have a long history of on-time payments, it can prove to be especially important in improving your credit scores.
Checking Your Credit Before Shopping
It can be easier to qualify for a secured loan than it is to qualify for an unsecured loan. However, your creditworthiness can still be an important factor in deciding whether you will be approved or not, how much will you be able to borrow and the interest rate that is offered to you. To see where you currently stand, you can check your credit score and credit report for free.
Sometimes, it makes better sense to focus on improving your credit before you take out a large loan. However, if you are not able to wait, you may be able to get approved for refinancing or a home equity loan even if you do not have great credit.
Taking any kind of loan can be a big decision. Before deciding how to use your home equity, you should consider the following factors:
- A home equity loan will deposit all funds upfront and the loan would have to be paid with a fixed interest rate. This can be a good option if the interest rates are low.
- A HELOC works like a credit card which can allow you to pull funds when you need them. And then you can pay them back after the draw period ended. HELOCs can have variable interest rates. However, some banks can also let you lock in a rate on either some or all of your balance for a fee.
- A cash out mortgage refinance can replace your mortgage and extend your mortgage terms. However, it can be the right choice for homeowners that need cash but also plan on refinancing.
So to answer the question, “which is better: cash out refinance or home equity loan?”, it can vary depending on how you want to use your home equity. This is a decision you should make yourself or take the help of a professional to help you figure out which one would be the best option for you.
Cash out refinancing and home equity loans can benefit homeowners who want their home equity to turn into cash. However, if you want to decide whether it is the best move for you, you should consider how much equity is available to you, what you will be using the money for and how long you actually plan to stay in your home.