Home equity loan vs. cash-out refinance: What’s right for you?

What's on your financial to-do list? Maybe it's paying off credit card debt. Or maybe it’s that kitchen reno you've been thinking about. 

Setting goals is a good thing, and sometimes, you need money to make your goals a reality. If you own a home, you might have a way to get the money you need. 

A home equity loan lets you borrow against your home without changing your existing mortgage, while a cash-out refinance replaces your current mortgage with a larger one. The right choice depends on your current mortgage rate, and whether you want to keep your existing loan.

Not sure which one is for you? We’ll explain the difference between a cash-out refinance loan and a home equity loan, and when each one might make sense.  

Home equity loan vs. cash-out refinance: the key differences

Here’s a quick summary to keep in mind between a cash-out refinance and a home equity loan:

Let’s take a closer peek at how each loan works.

What is a cash-out refinance?

A cash-out refinance mortgage replaces your old mortgage with a new, bigger loan. The new loan is bigger because it includes:

• The amount you need to pay off the old mortgage.

• The additional amount you're borrowing against your home equity. 

For example, say you owe $200,000 on your mortgage, and you apply for a $250,000 cash-out refinance loan. You're approved (yay!) and at closing, the lender pays off your old mortgage plus closing costs, then gives you the difference in cash. You've gotten a new, larger mortgage as well as cash out based on your home equity. 

Going forward, you'll make monthly payments against the new loan. In the meantime, you can use the extra cash pretty much any way you like. 

The repayment term on a cash-out refinance loan is typically 15 or 30 years, but some lenders also offer 10- and 20-year options. A longer term could mean lower monthly payments, but it will cost more in interest fees. Keep in mind that it will take longer to pay off your home overall If you get a longer term than you had remaining on your previous mortgage.

What is a home equity loan?

A home equity loan works as a way to borrow against your equity while leaving your original mortgage intact. The home equity loan is a second mortgage that you pay in addition to your existing mortgage. 

How much you can borrow will depend on how much equity you have in the house (how much it's worth over what you owe). If you’re approved, you get a single lump sum loan at closing. You can use the money for pretty much any expense.

After you get your home equity loan, you'll continue to make your regular mortgage payment each month—and you’ll also make a monthly payment for your home equity loan. As an installment loan, home equity loans have consistent monthly payments for the entire term. Most home equity loans have a term of five to 30 years.

When a home equity loan might make more sense

In general, a home equity loan might be better in cases where you:

• Are unlikely to get a lower mortgage rate than you’re already paying.

• Are okay with handling two separate debts for your home.

• Don’t want to pay the higher closing costs that come with a full refinance.

• Don’t want to reset the payment progress you’ve already made on your mortgage.

Here's an example: Let’s say you’re 10 years into paying off your 30-year mortgage, and you still owe $200,000 at 5% APR. You want to build a $20,000 addition onto your home, but rates are currently around 6% APR. 

If you refinanced your mortgage with another 30-year loan, it’d take 10 more years to pay off your home—and at a higher interest rate. Plus, you’d pay closing costs on $200,000, not just the $20,000 you need. So, you decide to opt for a home equity loan instead. 

When a cash-out refinance might make more sense

On the flip side, here are some signs that a cash-out refinance might work out better for you:

• You’d be able to get lower rates on a new mortgage than your current one.

• You only want to make one payment for your home.

• You’re comfortable paying more in closing costs.

• You want a smaller monthly payment, even if it means stretching out your loan.

• You’re okay with changing your term length, even if it takes longer to pay off your home.

Here's an example: Let’s consider the same scenario from above. This time, let’s assume your credit wasn’t so hot when you first bought your home so you’re still paying an interest rate of 8% APR on your current mortgage. 

You’ve worked hard to build your credit and you can now qualify for that 6% APR. So, you decide to use a cash-out refinance, because you can lower your overall mortgage rate while borrowing the cash you need. 

How to decide which option is right for you

Still confused? We’ve got you. Here’s a quick point-by-point rundown of what to consider when deciding between a cash-out refinance vs. home equity loan:

• Do you like your current mortgage rate? If yes, a home equity loan could be better. A cash-out refi could be the right choice if you can get a lower rate on a new mortgage.

• How long do you plan to stay in the home? Consider a home equity loan if you’ll be moving in the next few years, since it’ll take longer to recoup the higher closing costs associated with a cash-out refi. 

• When do you want to pay off your home? A home equity loan could be right if you want to stay on track with your original home payoff schedule.

• How much closing costs do you want to pay? A cash-out refinance will typically have higher closing costs than a smaller home equity loan.

Remember, these are general guidelines, and the math may be different for you depending on the interest rate, term length, and closing costs for your new vs. your old loan. Use online loan calculators to crunch your own numbers. Pay close attention to your monthly payment and total interest paid, since that’ll directly affect your short-term cash flow and long-term wealth building.