Cash out refi vs. home equity loan: What you need to know

If you want to refinance your home’s mortgage loan, you have a few options, including a cash-out refinance and a home equity loan. If you’ve built plenty of equity in your property and plan on selling your home within a few years, refinancing a first mortgage with a home equity loan can make sense.

Here’s what you should know about a cash-out refi vs. home equity loan.

What’s the difference between a cash-out refi vs. home equity loan?

A home equity loan and a cash-out mortgage refinance can be used for similar purposes, like funding a major project or expense, and both use the equity in your home as the source of the funds. Both also use your home as the collateral for the loan, so If you default on either refinancing option, you risk foreclosure.

The main difference between a home equity vs. cash-out refi is how each financing option is set up.

Cash-out refinance

A cash-out refinance pays off the remaining balance on your first home loan and replaces it with a new mortgage loan. The newly refinanced loan amount is for the remaining debt owed on the first mortgage, plus the amount you’re “cashing out” from the equity.

Cash-out refinancing may have a different interest rate and a different repayment timeline, but refinancing terms can be up to 30 years.

Some lenders and federal programs may set lower credit score requirements for cash-out refinancing. Since the refinancing lender assumes the first mortgage during a cash-out refi, that lender becomes the primary lienholder in the event of a default. With easier access to your home as collateral, lenders might be willing to offer lower rates compared to a home equity loan.

Takeaway: A cash-out refinance can be an option for homebuyers to borrow a lump sum for planned expenses. It also may be a simpler refinancing option in that you’ll still have one mortgage loan to keep track of.

Who it’s best for: Borrowers who don’t have excellent credit might have a better chance at getting approved for a cash-out refinance.

Home equity loan

A home equity loan is often regarded as a way to fund one-time large purchases or projects, like a home improvement. However, a home equity loan can also be used as a refinancing tool if you’re hoping to lock in a lower mortgage rate.

A home equity loan is a second mortgage against your home, with its own terms and interest rate that are separate from your first mortgage. By refinancing using a home equity loan, you’re borrowing against the home’s equity — the difference between the market value of your home and what you owe on the first loan. You can typically borrow up to 85 percent of your home’s equity, but your loan amount is also contingent on other financial factors, like your income and credit history.

According to Experian, homeowners usually need a FICO score of 680 or higher to qualify for a home equity loan.

Home equity loan rates may be higher than other refinancing options. The differences, however, vary significantly from bank to bank and over time. Home equity loans generally have a repayment period of up to 30 years, and some lenders may not charge origination fees, which results in lower (or no) closing costs. Also, home equity loans don’t require mortgage insurance that a cash-out refinance might require.

Takeaway: A home equity loan is an option for those who’ve built up a lot of equity in their homes. More equity in your home means you can borrow a larger amount to pay off your first mortgage while putting any loan surplus toward another expense, like home improvements.

Who it’s best for: This financing alternative is ideal for homebuyers who have strong credit scores. It also might make sense for borrowers who find lenders that waive home equity loan closing costs. If you can qualify for a significantly lower home equity rate than your current mortgage rate, this refinancing approach may help you save on loan costs.

Refinancing with a 15-year cash-out refi vs. a 15-year home equity loan

In this scenario, refinancing with a cash-out refinance loan is cheaper, despite its higher closing costs and loan amount. This is because the cash-out refinance interest rate is significantly lower than the home equity loan rate.

Refi with 15-year cash-out refi Refi with 15-year home equity loan
Loan amount $170,000 $150,000
Closing costs $2,400 $600
Interest rate 2.59% 5.66%
Monthly principal and interest $1,140.76 $1,238.40
Total cost in first 24 months $29,778.24 $30,321.60
Total cost in first 48 months $57,156.48 $60,043.20
Total cost in first 60 months $70,845.60 $74,904

The bottom line

A home equity loan can be a strategic way to access the equity you’ve built in your home while possibly finding a lower interest rate. Whether a home equity loan or cash-out refi is the best approach depends on your financial factors and your goals for the loan funds.

Regardless of which refinancing path you choose, always compare multiple home equity lenders and cash-out refinance offers. Always ask for an itemized list of associated fees so you can calculate how much a home loan costs in the short- and long-term.

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