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Cash-out refinancing and home equity loans let you use your home as collateral to borrow money. Figuring out which option is best for you may depend on your current mortgage, how much equity you have in the home, lenders' offers and your creditworthiness.
What Is a Cash-Out Refinance and How Does It Work?
A cash-out refinance is a mortgage loan that allows you to borrow some of your home equity by replacing your current mortgage with a new one. The new loan will be for more than your previous balance, and you'll get the difference in cash.
The process can be similar to taking out your first mortgage and may require an appraisal to determine your home's value. Generally, you can borrow up to about 80% to 85% of the home's value. However, if your loan-to-value (LTV) ratio is above 80%, you may need to pay for private mortgage insurance on your new mortgage.
For example, if your home is appraised for $300,000, 80% of that is $240,000. If your current mortgage balance is $200,000, you may be able to get a cash-out refi for $240,000 and receive the $40,000 in cash.
You'll then repay the loan based on the terms of your new mortgage. Similar to a purchase mortgage, you may be able to choose between a fixed and variable rate and often 15- to 30-year terms on your refinance.
Ideally, you can qualify for a lower interest rate, which will also help you save money. However, closing costs could offset some of the savings.
How Does a Home Equity Loan Work?
A home equity loan is a type of second mortgage that you can take out in addition to your primary mortgage. There are also home equity lines of credit (HELOCs), which are similar, but give you a line of credit that you can borrow against rather than the entire loan amount upfront.
With a home equity loan, some lenders may allow you to borrow up to 85% to 90% of your home's value based on the combined loan-to-value ratio (CLTV), which takes the balance of your first mortgage and the home equity loan into account. Continuing with the figures above, if your home is worth $300,000, 90% of that is $270,000. If your current mortgage balance is $200,000, you may be able to get a home equity loan for $70,000.
Getting a home equity loan may be quicker if the lender doesn't require an in-person appraisal, and some lenders cover the closing costs on the loan. Home equity loans also often have fixed rates and shorter terms than primary mortgages, but you'll be making monthly payments on both your home equity loan and original mortgage. If you fall behind on either loan, the lender may be able to foreclose on your home.
Comparing a Cash-Out Refinance With a Home Equity Loan
Both cash-out refinancing and home equity loans can help you turn the equity you've built in your home into money you can use today. Many people use these forms of financing for home repairs, maintenance or improvements, or for major expenses, such as a wedding or college costs.
Although there are exceptions, here are some general differences between cash-out refinance mortgages and home equity loans:
|Cash-Out Refinance||Home Equity Loan|
|Replaces Current Mortgage||Yes||No|
|Interest Rates||Fixed or variable||Often fixed|
|Repayment Term||15 to 30 years||5 to 30 years|
|Closing Costs||Yes||Lenders may cover the costs|
|Tax Deductible||If you use the money to improve the home||If you use the money to improve the home|
Home equity loans tend to have higher interest rates than cash-out refinancing loans as they're second mortgages, meaning that if you fall behind on payments, the lender will only get paid after the primary mortgage holder gets what it's owed. The higher interest rate may be somewhat offset by the low or no closing costs. But read the fine print on your loan, as some lenders will cover the closing costs but then require you to repay some of the money if you pay off your home equity loan early.
Should I Use a Cash-Out Refinance or Home Equity Loan?
Deciding between cash-out refinancing and a home equity loan can depend on how much equity you've built in your home, your creditworthiness and lenders' current offers.
If using a cash-out refi would mean increasing your mortgage's rate or adding private mortgage insurance, then the higher monthly payment and long-term costs may not be worth it. However, if you can lock in a lower mortgage rate and get some cash out of your home at the same time, then a cash-out refi can be a win-win when you need to borrow money.
A home equity loan might be a better option if you want to borrow a large portion of your home's value, or if you can't find a lower rate when refinancing. The monthly payments may be higher if you choose a shorter-term loan, but that also means you'll pay less interest overall.
How a Cash-Out Refinance and Home Equity Loan Affect Credit
Overall, the amount you owe and the impact to your credit scores may be similar with a cash-out refinance and a home equity loan. The main difference is that a cash-out refinance will lead to paying off and closing your original mortgage, while a home equity loan only will be an additional loan. However, the paid-off loan can stay on your credit report for up to 10 years and continue to impact your scores during that time.
Home equity loans and cash-out refinancing both involve taking out a new installment loan. In either case, lenders may review your credit reports with a hard inquiry. Also, when your loan is added to your credit reports, the average age of accounts on your reports will decrease, and your loans will have a high balance relative to their original loan amount. These factors can all hurt your scores a little, but they're minor factors.
Once you start to repay your new loan, your on-time payments can be reported to the credit bureaus and help your credit. Having a long history of on-time payments can be especially important for improving your credit scores.
Check Your Credit Before Loan Shopping
It can be easier to qualify for a secured loan than an unsecured loan, but your creditworthiness can still be an important factor in whether you'll get approved, how much you can borrow and the interest rate you're offered. You can check your credit score and credit report for free to see where you currently stand.
Sometimes, it may make sense to focus on improving your credit before taking out a large loan. However, if you're not able to wait, you may be able to get approved for refinancing or a home equity loan even if you don't have excellent credit.