Americans are sitting on a lot of home equity, thanks to the hot housing market of the past few years.
The average person paying back a mortgage in spring 2022 had $280,000 in equity -- a $125,000 increase over the past five years -- according to data from CoreLogic, a financial services company.
You don’t have to sell your home to take advantage of that increase in value. Instead, cash-out refinances and home equity loans are both ways to borrow money based on the equity you’ve accumulated. If you’re considering tapping your equity to cover some major expenses, it’s important to understand the key differences between cash-out refinances and home equity loans.
What is a cash-out refinance?
Homeowners looking to tap into their home’s equity may consider a cash-out refinance. This type of financing replaces your existing mortgage with a new one for a higher amount. Because the new mortgage will exceed the balance of your existing mortgage, the funds will pay off your first mortgage and you’ll receive the difference in cash. The money received can be used for almost anything, but it’s still a loan. You’ll have to pay it back at a new interest rate and with a new, longer term.
Refinancing is popular among homeowners looking to get a lower interest rate on their loan. However, because of inflation and the surge in mortgage rates over the last year, many homeowners are unable to get a lower interest rate with a cash-out refinance.
A cash-out refinance is an alternative to other types of home equity financing, namely home equity loans and lines of credit, aka HELOCs.
How it works
Your home’s equity is the difference between the current value of your home and what you owe on your mortgage.
Let’s say your home is worth $400,000 and you still owe $75,000 on a current mortgage. This means you have $325,000 of equity built up. You want to get a cash-out refinance so you can remodel the kitchen and the bathroom. Most lenders will allow you to borrow up to 80% of the home’s total value. So, in this case, you technically could qualify for a cash-out refinance amount of up to $320,000.
But you only want a $175,000 cash-out refinance. The loan pays off the existing mortgage, meaning you’ve effectively cashed out $100,000 of the home’s equity.
You’ll pay back that loan -- in this case, $175,000 -- with an updated (ideally lower) interest rate and new term.
One consolidated loan to manage and pay back
Ability to qualify with a lower credit score
Interest rates are lower than personal loans and credit cards
Potential tax benefits (you can deduct interest if you’re using the loan to improve your home)
Comes with a new set of closing costs (and hefty taxes in some states)
Requires a long time to close -- an average of 49 days, according to ICE Mortgage Technology
Rising rate environment could result in a more expensive mortgage
Risk of foreclosure if you don’t pay refi back on time
Who might be a good candidate for a cash-out refinance?
A homeowner who needs to access the equity in their home to pay for a major expense or consolidate debt should consider a cash-out refinance. However, they make the most sense if you can get a lower interest rate than the one on your primary mortgage, and if you plan on being in your home for many years to come.
You’ll want to have a fair to good credit score and have at least 20% equity in your home -- this is typically the amount lenders require you to maintain when borrowing. These and other requirements will vary from lender to lender.
What is a home equity loan?
A home equity loan is a second mortgage. Unlike a cash-out refinance that replaces an existing mortgage, a home equity loan is a second loan that allows you to tap into your home’s equity without disturbing the rate on your primary mortgage. You’ll keep paying off the original mortgage and have a second mortgage to manage too. A home equity loan affords you a one-time lump sum of cash that you pay back at a fixed rate over a period of time (anywhere from five to 30 years).
The most common uses for a home equity loan include home improvements, debt consolidation and other large expenses such as medical emergencies.
How it works
Let’s reuse the same numbers from the example above. You have a $75,000 outstanding balance on your current mortgage and the home is worth $400,000, meaning you have $325,000 of equity. Most lenders will allow you to borrow up to 85% of the equity in your home.
Because you have an existing mortgage of $75,000, you might be able to qualify for a home equity loan up to $276,250 -- 85% of your home equity.
The loan amount, interest rate and other terms will depend on a few factors -- your credit score, debt-to-income ratio and loan-to-value ratio to name a few.
Some lenders can close much faster -- between two and four weeks -- than with a cash-out refi
Some lenders don’t charge additional closing costs (although you’ll still likely pay for an appraisal, title services and other fees)
Lower rates than personal loans and credit cards
Potential tax benefits (can deduct interest if you’re using the loan to improve your home)
Often requires a higher credit score for approval
Higher interest rates than refinances
Risk of foreclosure if you don’t make on-time payments
Two separate mortgages to manage
Who might be a good candidate for a home equity loan?
A homeowner who needs additional cash but already has a low interest rate on their existing mortgage may consider a home equity loan. Borrowers managing a large expense, such as a home renovation or seeking to consolidate debts at one time, might find a home equity loan attractive because of the lump sum of cash it provides.
The requirements for a home equity loan are similar to those for a cash-out refinance. However, you may need a higher credit score -- lenders tend to look for a credit score of 700, but some accept scores as low as 620.
Cash-out refinance vs. home equity loan: Which one is right for you?
There isn’t a one-size-fits-all answer when comparing a cash-out refinance with a home equity loan. Here are a few key factors to consider.
The interest rate on your current mortgage: Generally, refinancing only makes sense if you can lower your interest rate. So, if you’re paying 7% on your current mortgage, and you can find a cash-out refinance option for 6%, this might be a smart move. However, if you refinanced during the pandemic boom of refinancing and managed to lock in a 3% interest rate, a cash-out refinance likely doesn’t make sense now.
How quickly you need the cash: Home equity loans tend to close faster than refinances. So, if you’re looking to start a project soon, you may want to look for lenders who can close and distribute your funds on an accelerated timeline.
Your credit score: Because a lender who reviews your cash-out refinance application has first dibs on your home in the event of a default, you’ll likely be approved with a lower credit score. Home equity lenders are second in line -- hence the phrase “second mortgage” -- so you’ll typically need a higher credit score for these loans.
The bottom line
Cash-out refinances and home equity loans are both options to access cash based on the amount of equity you’ve accumulated as a homeowner. While each can help you access the cash you need to help deal with big expenses such as remodeling your home, paying off high-interest credit cards or covering a child’s college education, there are unique differences between the two. Most importantly, they share a common rule you should keep in mind before taking on more debt: If you don’t pay them back, you can lose your home.
A no-cash-out refinance is exactly what it sounds like: You won’t be borrowing any additional money. These are often called rate-and-term refinances because the borrower opts to adjust their rate and term to lower their monthly payments and/or accelerate the time to pay off the loan.
It’s unlikely you’ll be able to cash out the entirety of your home’s equity. The maximum amount you can borrow will vary from lender to lender, but the average is usually between 75% and 90% of the value of the home. The amount you can borrow will also depend on your credit score, debt-to-income ratio and loan-to-value ratio.
Just about anything: There aren’t restrictions about what you can do with cash you borrow via cash-out refinance or home equity loan. The best use of the funds from a cash-out refinance or a home equity loan is to make a substantial improvement to your home -- taking out equity to build more equity by remodeling the kitchen or installing a new bathroom, for example. These also qualify for tax deductions.