Cash-Out Refinance vs Home Equity Loan: Best Choice?

Homeowners in the US hold over $35 trillion in home equity. This wealth provides a chance to access funds for many like home improvement. You can tap into this equity mainly through cash-out refinancing or home equity loans.

Each method works differently and comes with its own set of benefits and risks. Selecting the wrong option could impact your long-term financial health. In this guide, we’ll break down the key differences, explain how each option works, and outline qualification requirements—so you can confidently choose the best solution for your needs..

A cash-out refinance involves replacing your existing mortgage with a new, larger loan. The difference between the new loan amount and what you owe is disbursed to you in cash, allowing you to utilize a portion of your home's equity.

This process is useful for homeowners who want to consolidate debt, finance home upgrades, or manage large costs.

Here's a step-by-step breakdown:

• New Loan Application: You apply for a new mortgage that is larger than your current loan.

• Assessment of Home Value: Determine your home's current market value through an appraisal.

• Calculate Available Equity: Subtract your outstanding mortgage balance from the appraised value to find your equity.

• Determine Loan Amount: Lenders typically allow you to borrow up to 80% of your home's value. For instance, if your home is valued at $300,000 and you owe $150,000, you might refinance into a $240,000 loan (80% of $300,000). After paying off the existing $150,000 mortgage, you'd receive $90,000 in cash.

• Loan Approval: You must qualify for the new loan based on your credit score, income, and debt-to-income ratio.

• Finalize the New Mortgage: The new loan comes with its terms, potentially including a different interest rate and repayment schedule.

While lenders often cap the loan-to-value (LTV) ratio at 80%, some programs may offer different limits based on creditworthiness and loan type. It's important to consult with your lender to understand specific LTV requirements.

Keep in mind, certain loans like FHA require FHA mortgage insurance, which can impact your refinance amount.

Funds obtained from a cash-out refinance can be used for various purposes, such as:

• Home Improvements: Improving your property's value through renovations.

• Debt Consolidation: Paying off high-interest debts to streamline payments.

• Educational Expenses: Financing tuition or other educational costs.

• Investments: Allocating funds toward investment opportunities.

Consider a cash-out refinance if:

• Interest Rates Are Favorable: Securing a lower rate than your current mortgage can lead to savings.

• You Need a Lump Sum: For significant expenses that require immediate funding.

• Debt Consolidation: To combine multiple debts into a single, potentially lower-interest payment.

If you’re exploring ways to restructure your mortgage beyond refinancing, you might also consider recasting your mortgage, which can help reduce monthly payments without changing your interest rate.

For veterans, options like VA loan assumptions can further simplify refinancing if you're transferring or selling your property.

Qualification criteria generally include:

• Sufficient Home Equity: Having enough equity to meet LTV requirements.

• Credit Score: A higher credit score can secure better terms.

• Debt-to-Income Ratio (DTI): Lenders assess your ability to manage new debt alongside existing obligations.

• Employment and Income Verification: Proof of stable income to ensure repayment capability.

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A home equity loan allows you to borrow against the equity in your home, providing a lump sum that you repay over a fixed term with set monthly payments. It is often used for significant expenses like home repairs or college tuition.

The process involves:

• Determining Available Equity: Similar to a cash-out refinance, assess your home's value and subtract the outstanding mortgage balance.

• Applying for the Loan: Submit an application specifying the desired loan amount.

• Receiving Lump Sum: Upon approval, receive the entire loan amount upfront.

• Repayment: Make fixed monthly payments over the loan term, which includes both principal and interest.

• Purpose: Mortgages are used to purchase homes, while home equity loans tap into existing equity.

• Secondary Loan: A home equity loan is an additional loan, leaving your original mortgage intact.

• Interest Rates: Home equity loans often have higher interest rates compared to primary mortgages due to the increased risk for lenders.

• Payment Structure: You'll have two separate monthly payments, one for your original mortgage and one for the home equity loan.

Yes, a home equity loan is often referred to as a second mortgage because it's an additional loan secured by your home, subordinate to the primary mortgage.

Consider a home equity loan if:

• Low Existing Mortgage Rate: Preserving a favorable rate on your primary mortgage while accessing funds.

• Fixed Interest Rate Preference: Desiring predictable monthly payments over the loan term.

• Specific Funding Needs: When you have a defined expense, such as a home renovation project.

Qualification requirements typically include:

• Adequate Home Equity: Lenders often require a minimum of 20% to maintain a certain percentage of equity after the loan is disbursed.

• Creditworthiness: A mid-600s credit score or higher is often required. A strong credit history can improve approval chances and secure better rates.

• Stable Income: Proof of consistent income to cover the additional loan payments.

• Acceptable DTI Ratio: Ensuring your income sufficiently covers existing debts plus the new loan payment.

Both cash-out refinances and home equity loans allow you to tap into your home's equity. The difference between your home's market value and the outstanding mortgage balance is important. Using this equity can help cover big expenses. However, it’s important to borrow wisely to protect your homeownership.

While accessing your home's equity provides cash, it also means taking on additional debt. This increases your monthly obligations and depending on the loan terms, could extend your repayment period. It's essential to assess your financial situation to ensure you can comfortably manage the increased debt load.

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The tax implications of these financial products depend largely on how you use the funds:

• Interest Deductibility: The IRS allows you to deduct mortgage interest on loans if the funds are used for substantial home improvements. However, if the money is used for other purposes, like paying off credit card debt, the interest may not be deductible.

• Non-Taxable Proceeds: The cash received from either option isn't considered taxable income since it is a loan that must be repaid.

Given the complexities, it's advisable to consult with a tax professional to understand the specific implications based on your circumstances.

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A cash-out refinance replaces your existing mortgage with a new, larger one, providing the difference in cash. In contrast, a home equity loan is a separate, second mortgage that allows you to borrow against your home's equity without altering your original mortgage.

Yes, both options involve closing costs. Cash-out refinances typically have higher closing costs, similar to those of the original mortgage. Home equity loans usually have lower closing costs, but it's essential to compare specific lender fees.

A homeowner might opt for a home equity loan if they're satisfied with their current mortgage rate and terms, and prefer not to alter them. This option allows access to funds without refinancing the existing mortgage.