Cash Out Refinancing Versus Home Equity Loan
One of the big advantages of owning a home – and there are many – is the ability to leverage the value of a home to borrow cash.
Two ways of doing so are via a cash out mortgage refinancing loan and a home equity loan.
Which of those cash-funding options a homeowner selects depends on multiple factors, especially with the owner’s current mortgage amount, the estimated value of the home and property, the borrower’s credit standing, and the loan selection quality offered by various lenders.
One thing’s for sure – a credit-qualified homeowner can get a good interest rate deal on refinancing loans in early 2021. According to FNMA, average mortgage-related refinance loan rates stand at 3.78% for a 30-year fixed mortgage loan and 2.78% for a 15-year fixed-rate mortgage loan ».
Home equity loan rates are higher, due to their differing credit standards, loan amounts and repayment terms. Right now, average home equity interest rates are in the 5.85%-to-6.00% range ». That gives a cash out refinancing loan the early edge against home equity loans, at least from an interest rate point of view.
But there’s more to the mortgage loan comparison experience than interest rates. Let’s take a closer look at both cash out refinancing and home equity loans, and see which one makes sense for you.
Both Loans Defined
Cash out refinancing. A cash out refinancing loan has the potential to provide a lower home interest rate along with cash-in-pocket for credit-worthy homeowners.
“A cash out refinance allows you to take out a new loan up to 80% of your houses appraised value to pay off your current loan and keep the rest in cash,” said Thomas Kalagher, a loan officer with Fairhope Mortgage in Fairhope, Al.
“The cash out figure could be tens of thousands of dollars or more. This keeps the interest rate low and frees up cash to pay off bills, do a renovation, install a pool, or anything else you need the money for. You typically lower your
current interest rate and get money out.”
Home equity loan. A home equity loan is more limited in scope than a traditional refinancing loan. “A home equity loan doesn’t touch your existing loan and only allows you to take money out up to 80-90% of your home’s value,” Kalagher said.
While a cash out refinancing loan can replace an existing mortgage loan, a home equity loan works within the financial parameters of a current home loan for approval purposes, but structurally, it’s not the same loan.
“A home equity loan allows a borrower to obtain a fixed amount at a fixed interest rate without refinancing the entire mortgage,” said Noah Damsky, principal of Marina Wealth Advisors in Los Angeles, Cal. “The home equity loan is in addition to the existing mortgage and does not replace it.”
Pros and Cons of Cash Out and Home Equity Loans
Like any consumer financial product, cash out refinancing loans and home equity loans have their upsides and downsides. It’s up to homeowners to know the risks and rewards of both loans and choose the loan that best meets their personal financial needs.
Cash out home loan “pros”
Tax-free. “With a cash out loan, the borrower has a fixed rate loan and the cash out received from the refinance is tax free and not considered as capital gains or taxable event,” said Jim Angleton, president of Miami, Fla.-based Aegis Finserv Corp., which creates mortgage loans.
Efficiency and value. Tapping into the equity in your home to use for other spending needs is a valuable resource for homeowners. “Doing so at ultra-low interest rates in the current environment can be very cost-effective,” Damsky said.
Freedom to spend. Borrowers can use the proceeds from a cash-out refinance for an purpose. “Consolidating and paying credit card debt is one of the most popular uses of the cash-out refinance loan,” said Michael Micheletti, director of corporate communications at Freedom Debt Relief in San Mateo, Cal.
Cash out home loan “cons”
Cash out loans are a one-off. “On the downside, a borrower can only take out cash a single time, starting at the original mortgage closing,” Kalagher said.
A cash out refinance adds more debt to your balance sheet. “Too much debt can be dangerous and place a borrower’s financial security at risk,” Damsky said.
May come with a higher rate. A cash out refinance will typically cost more (i.e., with a higher interest rate) than a
typical mortgage when compared to the interest rate you would pay to purchase the same home today. “Lenders view cash out refinances as higher risk than a typical loan, which causes the interest rate to increase,” Damsky noted.
High loan fees. In addition, a refinance carries loan costs that can exceed $3,000-$5,000,” Damsky said.
Hefty home loan is a risk. With a cash out loan, homeowners take on a big risk by increasing the loan balance. “In the event property values decline, a higher loan balance can steer you underwater on your mortgage down the road, if you can’t pay off the mortgage,” said Bill Samuel, a residential real estate developer at Blue Ladder Development in Chicago, Il.
Home equity loans “pros”
Multiple payouts. With a home equity loan, a borrower can obtain cash multiple times or “up to the credit line value,” said Angleton. “You only make payments based on the amount of money used. Your loan payments will increase according to the amount owed and based on the interest at time of the payment, and they do have a base rate of interest and a ceiling ‘cap-rate’ limiting how much money can be borrowed.”
Lower upfront cost. Home equity loans can be obtained without origination costs like a
cash out refinance. “Terms are flexible and can be customized based on the need for the additional cash. Payments may also be tax-deductible if used for qualified expenses,” Damsky said.
Potentially lower rates. “Because lenders look at the real value of your home equity to secure the loan, they often can offer lower interest rates than they can for other types of unsecured loans,” said Micheletti.
Home equity loan “cons”
Interest rate costs may be higher. Home equity loan interest rates can be slightly higher than existing mortgage rates, but they may be competitive when factoring in the additional cost that comes with a cash out refinance, Damsky noted. “Costs are typically higher because they carry a fixed rate rather than a floating rate,” he said. “There is a higher cost to lock in a fixed rate.”
You’re on the clock. “While borrowers only pay interest on the exact amount borrowed for the exact amount of time,
there is a time limit for when your home equity line is due in full,” Samuel said.
Home equity loans also a long-term risk. As is the case with any loan using the home as collateral, you could face a foreclosure if you do not keep up with payments for any reason.
“If property values decline and you have tapped into too much equity in your home, you may put your home at risk should you need to sell or move quickly,” said Micheletti. “Borrowers must also qualify on the basis of your home’s loan-to-value ratio, your income and your credit profile.”
The Best Places to Find a Cash Out Loan and a Home Equity Loan
Both banks and online lending platforms are good places to start your home loan journey. That’s the case for either a cash out refinance loan or a home equity loan.
There are some caveats, however.
“If you have a relationship with an existing bank, ask them,” Damsky said. “Another good idea – utilize online aggregators that shop for the best terms for you. Reaching out to local real estate agents and professionals that can refer you to trusted contacts is another great resource.”
The Best Deal? It Depends Upon Your Situation
Determining whether a cash-out refinance or a home equity loan is a better deal is largely dependent on your personal situation, your time in the home, and the rates and terms of your existing mortgage.
“If you choose to do a cash-out refinance, you are effectively resetting your mortgage,” said Tricia Tetreault, senior financial analyst here at FitSmall Business in New York, N.Y. “This may make financial sense if the current interest rates being offered are lower than the rate on your current loan.
However, it’s important to consider the impact on the repayment term of the loan as well. “If you’re in year 10 of a 30-year mortgage, you only have 20 years of repayment left,” Tetreault added. “Refinancing your home with another 30-year mortgage restarts your repayment clock and extends your payments out an additional 10 years.”
A home equity loan differs, time-wise, and home owners ought to know that.
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“These loans generally have a shorter repayment term than a standard mortgage—generally five to 10 years—and repayment runs concurrently with your existing mortgage,” Tetreault added. “If your goal is to have your property paid off by a certain date (e.g. before you retire), a home equity loan can allow you access to funds without pushing out the term of your existing mortgage.”
Looking at the issue through an interest rate lens, there’s little doubt a cash out refinance loan gets the call as the “better deal.
“The best deal for customers these days are the cash out refinance, as interest rates are at all-time lows,” Kalagher said. “I just helped a customer with 19 years left on their mortgage refinance to a 15 year loan, pay off $30,000 in credit
card debt and the payment only went up about $50 a month, while paying off the mortgage four years earlier. That’s value.”
The future may change that experience, however, especially as interest rates rise, which most financial experts believe will happen.
“Five years from now if interest rates go up to 5%, it’s likely better to take out the home equity loan and keep your mortgage at today’s low rates in the 2% range,” Kalagher added. “It all depends on the situation.”
“That’s why talking to a qualified mortgage loan officer is so important.”
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Brian O'Connell has been a finance writer at TheStreet, TheBalance, LendingTree, CBS, CNBC, WSJ, US News and others, where he shares his expertise in personal finance, credit and debt. A published author and former trader, his byline has appeared in dozens of top-tier national publications.