So, you’re ready to get some of that delicious equity out of your home. Excellent! One of the likely reasons you chose to buy a home instead of rent was so you could build equity, so why not cash in, right? This also means there are probably a bunch of terms floating around in your head like closing costs, interest rates, refinancing, first mortgage, second mortgage and the list goes on and on. At the top of your list of questions may be whether a refinance or home equity loan is better. Fear not, here are all the ins and outs and factors to consider so you can make the best decision for your unique situation.
How Can You Use Home Equity?
You probably spent a good chunk of money to get your home, and that makes it a huge investment opportunity. Every time you make a payment, you gain equity in your home. That equity grows even faster in an environment where home values are rising.
Home equity loans and cash-out refinances are two options that allow you to access that value, or your home equity, to unlock the true investment potential of your home. They can be used to pay off home improvements, augment a college fund, consolidate debt or give your retirement fund a boost, just to name a few of the possibilities.
If you recently purchased your home, you may not have a lot of equity to work with. However, if you’ve been in your home for 5 or more years and make your payments on time, you’ll likely have equity.
To find out how much equity you have, calculate the difference between what your home’s value is and how much you still owe on the mortgage. If that number is positive and high enough, you’re likely to be a viable candidate for a cash-out refinance or a home equity loan.
Home Equity Loans Vs. Refinance: Similarities And Differences
At first glance, they may seem like the same thing, but understanding the similarities and differences between these options can help you make an informed decision on which one to choose.
- Both usually have fixed interest rates depending on the market environment, but can have adjustable rates.
- Both typically require an after-transaction loan-to-value ratio of 90% or less to qualify
- Both offer lump-sum payouts.
- Cash-out refis are one loan (as opposed to home equity loans, which essentially serve as an additional mortgage) and usually have lower interest rates.
- Home equity loan lenders typically pay all or most of the closing costs.
Home Equity Loans: Overview, Pros And Cons
You can use a home equity loan to refinance your first mortgage, a current home equity loan or a home equity line of credit. If you’ve built up equity, refinancing with a home equity loan could help when rates are high. As a side note, Rocket Mortgage® doesn’t offer home equity loans right now.
Home Equity Loans At A Glance
- You can borrow 80% – 89% of your home’s value (between a first and second mortgage)
- The loan isn’t taxable, but you may be able to deduct interest
- It’s a second mortgage, which will come with a higher rate than your primary mortgage
Home Equity Loan Pros
While there may be limits set by lenders or investors regarding how much of your existing equity you can take a loan against, you have the option to go with a fixed payment. That way, your payment never changes and you know what you’re getting.
Home equity loans also give you the flexibility to hold onto the existing rate and term of your primary mortgage if you’re happy with it. Some would rather have the flexibility of paying on a separate loan rather than touch their primary mortgage.
If you’re looking to purchase a home, there is the option to take out a primary mortgage and then use a secondary mortgage to bring your total equity down to 80% and avoid paying for mortgage insurance. This may sometimes be cheaper than the mortgage insurance policy.
Be aware that if you’re going to do this, your lender may require you to make a slightly higher down payment (e.g. 10% or more) in order to have the option to take a second mortgage.
Home Equity Loan Cons
Since home equity loans are a second mortgage, you’re going to pay a higher rate than you would if it were your first mortgage because lenders assume you’re going to make payments on your primary mortgage first.
Your home equity loan lender gets a lien on your house, but the primary lender’s lien takes precedence. In exchange for the additional risk, the lender on the second mortgage will charge you more.
Additionally, home equity loans taken out to do things other than build, buy or improve your home haven't featured tax-deductible interest since the 2017 tax year.
The last downside is that you have two mortgage payments to worry about. This last one is a big factor. Two mortgages can put a real strain on the monthly budget, so do the math and make sure you can make it work before you proceed.
Cash-Out Refinances: Overview, Pros And Cons
Like home equity loans, a cash-out refinance utilizes your existing home equity and converts it into money you can use. The difference? A cash-out refinance is an entirely new primary mortgage with cash back – not a second mortgage.
With any option, the more equity you have, the more you can take and convert to cash. The exact amount will depend on the type of loan you’re using and other factors, like your credit score. With a cash-out refinance, lenders typically limit the amount to 80% of the home’s value, leaving 20% equity. If you qualify for a VA loan, you can borrow up to 100% equity.
Cash-Out Refinances At A Glance
- You can borrow 90% of your home’s value (up to 100% with a VA loan)
- Easy to qualify for with the right FICO® Score and amount of equity
- Low interest
- 15 – 30-year payback, among other term options
- The loan isn’t taxed, but you may be able to deduct interest
- The interest rate would be lower than a home equity loan because it’s your primary mortgage
- You only have one mortgage payment
Cash-Out Refinance Pros
A cash-out refinance features many of the benefits of home equity loans, but with a couple of additional advantages.
The first big advantage is you’ll only have one mortgage against your house. That means there’s less risk for the lender and you’ll get a better rate than you would if it were a second mortgage. This is also why a cash-out refi is typically easier to qualify for, as it gives lenders first payback priority.
Another upside is low interest rates, which are good when trying to accomplish any financial goal. And, you’ll only need to budget for one mortgage payment.
Cash-out refinances are often the best way to consolidate debt because they’re based on your primary mortgage, so you’re getting the lowest possible mortgage rate for your financial profile.
As of this writing, mortgage rates are in the high 2% range. To put it in simple terms, rates are really, really low right now.
More benefits? Taking cash out to pay off high-interest debt like credit card balances, you can potentially save yourself a lot of money when compared to paying off the balances incrementally over time.
Cash-Out Refinance Cons
As previously discussed, if you want to take advantage of a cash-out refinance, you usually have to leave a minimum amount of equity within the home. Because of this, it’s very important to make sure that you can take out enough home value to accomplish your goal.
If you don’t have enough equity to get the job done, you might take a look at alternatives like a second mortgage or personal loan.
Although the lowest rates for taking cash out are available to those who refinance their primary property, you may wish to take a second mortgage if you really like your primary mortgage rate and don’t want your payment to change.
Which One Is Right For You?
Is the best option for you a home equity loan or cash-out refinance? The answer depends on your personal situation, and we absolutely recommend speaking with a financial advisor. In the meantime, here are some key points to consider:
Factors That Determine The Best Type Of Loan For Your Needs
It’s a lot to think about, right? What you qualify for is probably your initial question, and that can all be impacted by your credit score, title searches, appraisals, etc. In addition to your ability to qualify for a home equity loan or a refi, the following list of factors can also help determine the best type of loan for you.
- How much equity you have
- Your mortgage interest rate
- How much you’d like to borrow
- Your ideal repayment timeline
- If you want a fixed or flexible term
A Home Equity Loan Might Be Best If …
- You want to access your home’s value without affecting your primary mortgage
- You’re using a second mortgage to avoid paying for mortgage insurance
- You’re using it in place of or in combination with a cash-out refinance in order to access more of your home’s value
- Today’s rates are higher than your existing mortgage’s rate
A Cash-Out Refinance Might Be Best If …
- You have plenty of equity to accomplish your goal and you want the lowest rate
- You’re attracted to the low rate for debt consolidation purposes, home improvement or fortifying investments
- You would like to keep a single mortgage payment
The Bottom Line
As you can see, the options are plentiful and there are many pros and cons with every course of action. Look at them each through your own personal lens, taking into account your goals and personal finances, to decide which route is best for you. If you’re ready to get started with a cash-out refi through Rocket Mortgage®, you can apply online or talk to one of our Home Loan Experts.