Choosing between a home equity loan and a cash-out refinance
Home equity loan vs. cash-out refinance
- Home equity loans are second mortgages.
- Home equity loans are better for smaller amounts of money and quick repayment.
- Cash-out refinancing creates a new loan.
- Cash-out refinancing is better for longer repayment periods and lower monthly payments.
- Both provide a lump-sum payment based on home equity.
- Home equity loans include tax-deductible interest only if the proceeds are used to purchase, construct or improve a home.
No matter what reason you have for needing a quick infusion of cash — paying off debts, that home improvement project or paying college tuition — homeowners have options.
Home equity loans and cash-out refinances are two common ways to tap into your home’s value. They are similar loan products, but there may be situations where one would be preferable. First, you should understand how each works.
Home equity loan
A home equity loan is a second mortgage. The borrower does not replace their existing mortgage but takes out a new, lump-sum loan with an additional monthly payment. The loan amount is based on how much equity you have.
For example, if your home is worth $200,000 and your mortgage balance is $50,000, you have $150,000 in equity. Lenders commonly limit loan-to-value (LTV) ratios to 80 or 90 percent. So, in the above situation, an LTV at 80 percent sets the cap at $160,000, or 80 percent of the home’s $200,000 value. The borrowers could qualify for a home equity loan of up to $110,000, or the difference between the LTV cap of $160,000 and their first-mortgage balance of $50,000.
A cash-out refinance replaces your current mortgage with a new loan, so borrowers have one monthly payment rather than two. Similar to a home equity loan, the amount you can refinance for is based on your existing equity, and is distributed in a lump sum.
So, in the above example, a homeowner could take out a new loan for $200,000 — the full value of the home — pay off the existing mortgage balance of $50,000 and receive the difference of $150,000 in cash. The borrower essentially resets the loan, with new rates and terms.
Which is better?
Choosing between a home equity loan and a cash-out refinance is not always a simple, straightforward proposition. A homeowner’s individual circumstances, income and cash flow, as well as the amount of equity in the home, are all important factors.
If you’re simply looking to lower your interest rate and monthly payment while freeing up money for other purposes, a cash-out refinance may be the better choice. You’ll likely reduce your monthly payment because lenders typically offer terms of 20 to 30 years. Home equity loans commonly feature shorter terms of five to 15 years. If you have an adjustable-rate mortgage, refinancing to a fixed-rate loan can also create financial stability. And if you are on a fixed income, for example, you may not be able to afford the higher monthly payments a home equity loan is likely to have.
There are drawbacks to a cash-out refinance. Closing costs, such as application and processing fees, are typically much higher than with a home equity loan. Lenders may, in fact, waive all closing costs on a home equity loan. Title insurance is part of these costs. If you’re taking out a new mortgage loan, you’ll have to repurchase title insurance to protect the lender against any claims on the property. The one-time cost is based on the entire loan amount, not just the cash-out portion.
For these reasons, a home equity loan is usually a better choice if you’re looking to borrow a relatively small amount of money and you can repay it quickly. For example, if you need $25,000 for home repairs, the closing costs on a cash-out refinance can be as high as 7 percent of the new loan amount. You could drastically reduce or eliminate those costs with a home equity loan, even if your interest rate is somewhat higher. But if you need a larger amount for repairs — $100,000, for instance — the closing costs may equate to less than 1 percent of the loan amount.
Take the time to compare lenders and discuss all the available options. Lenders can provide good estimates for your costs and fees, as well as your monthly payments, which can help you make a wise choice.
Prior to 2018, interest payments on home equity loan amounts up to $100,000 were eligible for tax deductions. These rules changed following the passage of the Tax Cuts and Jobs Act. Homeowners may now deduct interest on up to $750,000 of all types of mortgage debt. Home equity loans and HELOCs are eligible for the deduction if you are using the proceeds to "buy, build or substantially improve the taxpayer’s home that secures the loan," the Internal Revenue Service said.