Choosing between a cash-out refinance and a home equity loan

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. Some people call it “taking cash out” or “leveraging your equity.” Whoa. No need to get fancy with the lingo. We’ll explain the difference between a cash-out refinance loan and a home equity loan, and when each one might make sense.  

Two ways to use your home equity

Having equity means your home is worth more than what you owe on it. Equity is your home’s value minus the amount you owe on your mortgage. 

A cash-out refinance and a home equity loan are two ways to essentially turn your home equity into spendable funds. Both are mortgages. In both, a portion of your equity is transferred from the lender to you in the form of money that you can use on your financial priorities.

Here’s how these loans work.

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 when you sign off on the loan, the lender pays off your old mortgage and gives the $50,000 difference to you in cash. That's where the "cash out" part comes in. 

Going forward, you'll make monthly payments against the new, bigger 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.

What is a home equity loan?

A home equity loan is a way to borrow against your equity while leaving your original mortgage intact. 

So how does a home equity loan work? The home equity loan is a second mortgage. The lender will check your credit to make sure you meet their minimum requirements. They will verify your income and other debts, and hire an appraiser to determine the market value of your home. Those details are needed to determine how much you can borrow. 

Once you’re approved (yay again!), you can use the money for pretty much any expense.

After you get your home equity loan, you'll continue to make your mortgage payment each month, and you’ll also make a monthly payment against the home equity loan. 

The home equity loan repayment period is usually between 5 and 30 years.

Cash-out refinance and home equity loan similarities

Cash-out refinance loans and home equity loans have the same goal: Helping you turn your equity into the cash you need. That's the biggest similarity, and here are a few more: 

• Flexibility. Whether you get a home equity loan or a cash-out refinance loan, you have a lot of freedom to decide what to do with that money. You might use it all for one big expense or to cover a handful of smaller expenses. Whether you want to consolidate credit cards, help your daughter pay for her dream wedding, or replace your old appliances, you can choose. 

• Tax benefits. Interest on cash-out refinance loans and home equity loans may be tax-deductible. To qualify for a tax break, you have to use the loan proceeds to improve or repair the home, and you have to itemize your deductions when you file your tax return.

• Fixed interest rate. Cash-out refinance loans and home equity loans usually have fixed interest rates. That means your rate won't change and your monthly payment won't change either. 

• Loan limits. No matter how much equity you have in your home, most lenders won't allow you to borrow all of it. Every lender's different, but most want you to keep your total debt under 80% to 85% of your home’s value. 

• Mortgage. Cash-out refinance loans and home equity loans are both mortgages. You pledge the home to the lender (also known as “using it as collateral”), and that lowers the lender’s risk. Loans that are backed by a valuable asset like your home tend to have lower costs than loans that aren't. That’s why mortgage and home equity loan rates typically come with lower interest rates than credit cards. 

Differences between a cash-out refinance and a home equity loan

A cash-out refinance and a home equity loan may sound alike, and they are in many ways. But they aren’t exactly the same. Here are the biggest differences between them:

• Structure. When you get a cash-out refi, you're paying off your old mortgage and getting a new one at today’s rates. With a home equity loan, you're keeping the old mortgage and getting a separate loan. This is a huge benefit if you snagged a mortgage at historically low rates in recent years and you don’t want to refinance to a higher rate.

• Interest rates. It’s possible to get either a fixed interest rate or a variable interest rate on a cash-out refinance loan. Home equity loans almost always come with a fixed interest rate. A fixed rate could be more valuable when interest rates are rising.

• Credit requirements. It may be possible to get a home equity loan even if your credit score is too low to qualify for a cash-out refinance. Many lenders require a 620 FICO score for a cash-out refi, but if you’re using the money to pay off other debts, you might qualify for a home equity loan with a 640 credit score.

When is a cash-out refinance a better choice?

You might consider cash-out refinancing if:

• You want to make a single loan payment each month

• Doing so will lower the interest rate on your current mortgage 

• Getting a new loan would lower your monthly mortgage payment 

• You want to restart the repayment term on your current mortgage 

When is a home equity loan better than a cash-out refinance? 

You might lean toward a home equity loan if:

• You don’t want to lose a very low interest rate on your current mortgage

• Handling the two mortgage payments won’t stress your budget 

• Your credit score is below 620 and you’re looking for a debt consolidation loan

• You want to pay off your home equity loan separately

Running the numbers through a cash-out refinance calculator or home equity loan calculator can give you an idea of what you might be able to borrow. You can also check out possible monthly payment amounts for different loan sizes. 

Fixed-rate HELOC

If you’re not sure how much you need or you don’t need it all immediately, consider shopping for a fixed-rate HELOC (home equity line of credit). A fixed-rate HELOC gives you the benefit of a fixed interest rate along with a five-year draw period. During the first five years, you can borrow, repay, and borrow more, up to your credit limit, as often as you want. You’ll only pay interest on the amount you actually borrow.

A drawback of traditional home equity loans is that you have to take the full amount of the loan up front, just like you do with a cash-out refinance loan. That means you’ll pay interest on the full amount even if you don’t need to use it all right away.