Have Home Equity? Cash-Out Refinances versus Home Equity Loans

What is a Cash-out Refinance?

A cash-out refinance replaces your existing mortgage with a new loan with a higher balance. The difference is then paid out to you in cash or a lump sum. You can use this extra money however you like, but many homeowners put it towards home improvement projects to raise the overall value of their homes. Others may use this money to pay off existing debts, such as student loans or credit card debt.

To qualify for a cash-out refinance, you typically need more than 20% equity in your home, although this number may vary by lender. This means you’ve paid off at least 20% of the principal amount of your mortgage loan. For example, if you still owe $150,000 on your original $250,000 mortgage loan, you have 40% home equity because you have paid off 40% of the principal amount, equal to $100,000.

You can also gain equity through home price appreciation. If you still owe $150,000 on your $250,000 mortgage, but your home is now worth $350,000, you actually have 57% home equity.

Review the balance on your mortgage loan to see how much you still owe and divide it by the current value of your home. Then take that percentage and subtract it from 1 to calculate your home equity. [($150,000/$350,000 = 0.43) (1 - 0.43 = 0.57 or 57% home equity)]

Most lenders will only loan you 80% to 90% of your home equity. For example, if you have $100,000 in home equity, the bank or credit union will pay you up to $80,000 or $90,000 in cash, depending on your credit score and overall debt-to-income ratio. However, that means taking on another $80,000 to $90,000 in debt on top of what’s left on your mortgage. The cash-out refinance replaces your old mortgage loan with a new interest rate and new terms and conditions. If you choose to refinance, you will also have a new monthly payment, which may be similar to or higher than the one you had before. Check to make sure you can afford the new monthly payment with interest before taking on additional debt.

To certify the new loan, the bank or credit union will also ask you to pay for the closing costs, which typically range from 2% to 5% of the principal loan amount. If you take out a loan for $240,000 (the remaining $150,000 on your mortgage + $90,000 in cash), you would have to pay between $4,800 to $12,000 in closing costs.

Use our home equity calculator to find out how much equity you have in your home:

How Does It Compare to a Home Equity Loan?

A cash-out refinance isn’t the same as a home equity loan or home equity line of credit (HELOC). All of these options can help you cash in on your home equity, but they come with different pros and cons.

A home equity loan gives you access to a lump sum of money based on your home equity, but you will have to repay this loan on top of your regular mortgage. A home equity loan won’t replace your existing mortgage; it’s issued on top of your mortgage, usually by the same lender.

HELOCs work more like credit cards. The bank or credit union issues you a line of credit up to a certain limit based on your existing home equity. You then have to pay off your debt for the amount of credit you utilized with regular monthly payments on top of your mortgage payments. As you continue making payments, your balance will go down, giving you access to more credit. Cash-out refinances typically have lower interest rates than home equity loans and HELOCs. Many people also prefer paying off one loan, so they don’t have to worry about making more than one payment.

Regardless of which option you choose, if you fall behind on your loan payments, cashing in on your home equity can put you at risk of foreclosure. Be sure to make your payments on time and don’t let your debt become unmanageable.

Which One is Right for You?

If you’re looking for a lump sum of money without replacing your existing mortgage loan, a home equity loan may be more appropriate for you. If you’d rather spend the money in installments, consider applying for a HELOC. HELOCs generally have lower closing costs than mortgages and are processed faster, which may be important if you need the money quickly. Since you’re only required to pay interest during the draw period, HELOC payments may be more manageable in the short term but will increase once the repayment period begins.

If you’d like to avoid taking on another loan on top of your mortgage but still need access to cash, applying for a cash-out refinance may be a better option. You can still take out a large sum of money without having to manage more than one loan. This can also help you lock in a lower interest rate if the current rates are lower than what’s on your original mortgage. Remember, you must have home equity to qualify for either of these options.

If it’s been several years or more since you refinanced your mortgage and you don’t need the extra cash, consider applying for regular refinancing. This replaces your old loan with a new interest rate without increasing the principal amount. You might be able to lock in a lower monthly payment with a lower interest, helping you pay off your debt as quickly as possible.

Knowing when to cash-out on your home equity isn’t always easy. Taking on more debt can be intimidating for some individuals. You should only consider this option if it will benefit you in the long term. Put the lump sum of money towards something that will help you earn more in the future, such as paying off your debt with a lower interest rate, earning a degree to advance your career or increasing the overall value of your home before you put it on the market.

If you need help deciding between a home equity loan and a cash-out refinance, contact the professionals at Ent Credit Union to speak with one of our member service representatives.