Choosing Between a Home Equity Loan or a Cash-out Refinance

 

Borrowing against one’s home equity is a popular option for people who need cash for one purpose or another.  But you’ve got several options for doing so.

A home equity loan or line of credit is the first thing most borrowers will think of. But a cash-out refinance of your current mortgage is another possibility and may be the better choice in some situations. 

With either option, the interest rates are low compared to many other types of borrowing, the interest paid is often tax-deductible and you can use the funds for any purpose you wish. So what’s the best choice?

Several factors will affect the decision of which option to choose. Among them are:

    • How much you want to borrow
    • When you want to pay it back
    • How much equity you have
    • Your current mortgage rate

Here’s a look at each option, along with the pros and cons.

Home equity loan or line of credit

A home equity loan is simply a loan secured by the equity in your property, that is, the portion of the value you own outright. So, if you have a $250,000 home and still owe $100,000 on the mortgage, you have $150,000 in home equity to work with. 

As a secured loan, home equity loans tend to have considerably lower rates than unsecured loans like credit cards or personal loans. And because they’re considered a second mortgage, borrowers who itemize can take a mortgage interest deduction on their taxes, up to certain limits.

With a standard home equity loan, you receive a certain amount of cash, which you immediately begin to repay over a certain amount of time, often 10-15 years and usually at a fixed interest rate.

Another variation is a home equity line of credit, or HELOC. With this, instead of borrowing a certain amount of money as a lump sum, the bank gives you a limit against which you can borrow against as needed. 

HELOCs have two phases, a draw period during which you can borrow money and a repayment phase when you pay it back.  You usually have to make interest payments during the draw period, which has an adjustable interest rate; the repayment period often changes to a fixed rate. You can also repay principle during the draw, which frees up more credit for you to draw against later on if need be.

Cash-out refinance

A cash-out refinance is a similar concept, except that instead of taking out a second mortgage, you borrow money as part of refinancing your primary home loan.

To use the example above, suppose you have a $250,000 home and still owe $100,000 on your mortgage. So if you wanted to borrow $50,000, you might do a cash-out refinance for $150,000 – the money borrowed is added on to your new mortgage total. You now have a $250,000 home with a $150,000 mortgage and $50,000 in your pocket (not counting fees).

Which to choose?

A home equity loan or line of credit is often the best choice for small- to medium loans.  There are little or no closing costs, and you can repay it separately from your primary mortgage, on a shorter timetable. 

A cash-out refinance is often a good choice for borrowing larger sums. That’s because while the interest rates on a refinance tend to be lower than on a home equity loan, the closing costs are significantly higher, because you’re refinancing your entire mortgage as well. So you need to borrow enough so that the savings on interest offset the higher closing costs.

However, a cash-out refinance also works when you can get a lower rate by refinancing than you’re paying on your current mortgage. In that case, the savings you get from lowering your overall mortgage rate may offset the higher closing costs you’d have versus a home equity loan or line of credit.

Here’s a rundown of the pros and cons of the different types relative to the other:

Home equity loan/line of credit

pros:

  • Low closing costs.
  • Separate from your main mortgage.
  • May be easier to obtain with limited equity.

cons:

  • Shorter repayment period.
  • Higher fixed and adjustable rates than cash-out refinance.
  • HELOC allows to borrow as needed.
  • HELOC can be used as a revolving fund, borrowing and repaying .

In addition, for a home equity line of credit:

pros:

  • Allows you to borrow what you need, when you need it
  • Works as an interest-only loan during the draw
  • Can be used as a revolving fund, borrowing and repaying as appropriate to balance out your cash flow.

cons:

  • Adjustable HELOC rate during draw could rise, increasing interest payments on debt already incurred
  • Interest-only payments during draw may tempt you into borrowing more than you should, by omitting the cost of repaying principle.

Cash-out refinance

pros:

  • Lower rate
  • Can reduce overall mortgage rate
  • Single monthly payment
  • Longest repayment schedule, up to 30 years, minimizing monthly payments
  • May be best for large amounts

cons:

  • High closing costs – need to refinance entire mortgage
  • Increase overall mortgage payment
  • Available only as a lump sum payout

Some downsides to home equity borrowing

Because home equity loans are mortgages, the application process is like a mortgage – you need an appraisal of your home value and submit pretty much the same information you’d need on any mortgage application. 

It also takes about the same length of time to be approved – usually 2-6 weeks. That’s not including the time to get your loan materials together. So if you need money in a hurry, you might consider other options.

The biggest factor though, is that you’re putting your home on the line. If the additional money you borrow with a home equity loan or cash-out refinance means you can’t keep up with your mortgage payments at some point, you could lose your home to foreclosure. So you need to decide how great that risk is and whether it’s worth the savings you’d realize by using a home equity secured loan.

Kirk Haverkamp is the editor and chief staff writer of MortgageLoan.com.  An award-winning reporter and editor with more than 25 years’ experience in journalism and public relations, his background includes working for the Romeo (MI) Observer, the Great Lakes Commission, the Michigan State University School of Journalism and being a contributor to such online publications as Credit.com, Investopedia and MetroMode Media.