Owning your home can have many benefits – from its basic role of providing shelter to helping you achieve long-term financial stability, as its value increases and you pay down the mortgage. Home equity is the difference between your home’s market value and the remaining balance on your mortgage loan or loans. You can convert that equity into cash to finance renovations, consolidate debt or use for other major expenses, typically by refinancing your mortgage or taking out a second mortgage loan.
If you’re unsure which of these options is best for your financial situation, understanding the advantages and disadvantages of both a home equity loan and a cash-out refinance is the first step.
Here, we break down how each type of loan works and outline the potential benefits and drawbacks to help you choose the best way to turn your equity into cash when you need it.
Key Takeaways:
- A cash-out refinance and a second mortgage are two ways to access your home equity and turn it into funds for renovations, debt consolidation or other financial transactions.
- A home equity line of credit and a home equity loan are both kinds of second mortgages.
- A refinance is a new mortgage loan that replaces your old one, with new terms and interest rate.
- A cash-out refinance replaces your current mortgage with a larger one. You receive the difference between what you borrowed and the new mortgage in a lump-sum cash payment.
Is Refinancing The Same As Getting A Second Mortgage?
Not exactly. Cash-out refinances and second mortgages are similar, in that both types of financing allow you to utilize the equity you’ve built in your home. However, they differ in how they affect your existing mortgage and monthly payments.
A refinance pays off your current mortgage and replaces it with a new home loan. The interest rate, loan term and mortgage payment amount can change when you refinance. The upside? You’ll continue to have just one mortgage payment and won’t have to worry about carrying a second lien on your home.
A second mortgage will neither replace nor change your existing mortgage. It is an additional mortgage or second lien on your home – hence the name. You’ll keep paying your regular monthly mortgage, but you will also be responsible for separate payments on the new loan – and making two mortgage payments each month may be difficult for some borrowers.
Let’s dive a little deeper into each financing option.
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What Is A Cash-Out Refinance?
A basic rate-and-term refinance changes the interest rate and/or loan term on your existing mortgage without increasing the loan amount. However, if you want to refinance your mortgage and take cash out of your home’s equity to cover expenses like debt consolidation, home improvements, or other large purchases, a cash-out refinance may be a better option. Like most refinancing solutions, it’s typically most beneficial when you can take advantage of a lower interest rate.
Here’s how the cash-out refinance works: Your lender pays off your existing mortgage and issues you a new loan – one that’s larger than what you owe on your mortgage. You receive the extra amount in cash and take on payments for the new mortgage balance. You’re essentially borrowing against the equity you’ve built in your home.
In most cases, though, you can’t withdraw all of the equity you’ve accumulated as a homeowner. Your lender will look at your loan-to-value ratio (LTV), which measures how much you’re borrowing compared to your home’s value. Most lenders want borrowers to have an LTV of 80% or lower. This means you can borrow up to 80% of your home’s value while keeping at least the 20% as your equity.
Cash-Out Refinance Example
Let’s say your home is appraised at $250,000 and your current mortgage balance is $175,000. In this case, you have $75,000 in equity. Most lenders allow you to borrow up to 80% of your home’s appraised value when you take out a refinance loan (up to $200,000 in this example), so you could potentially access around $25,000 in cash using a cash-out refinance. This money can be used for home improvements or debt consolidation.
You can use an online home equity calculator to help estimate how much equity you have in your home and how much of it you can tap into for cash.
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What Is A Second Mortgage?
A second mortgage is a loan secured against your home when it already has an existing mortgage in place. To qualify for one, you must still have sufficient equity in your property to use as collateral. The two main types of second mortgages are home equity loans and home equity lines of credit (HELOCs).
Home Equity Loan
This type of second mortgage allows you to borrow a lump sum in exchange for the equity you’ve built in your home. As with a first mortgage or a personal loan, you’ll typically repay a home equity loan in monthly installments. The terms typically include a fixed rate for the duration of the loan.
Home Equity Line Of Credit (HELOC)
Like a home equity loan, a HELOC lets you borrow money against your equity. But instead of receiving these funds in a lump sum, you receive the money as an open line of credit, much like a credit card.
There are two stages to a HELOC. First comes the draw period (usually 10 years), during which you can borrow from your credit line, repay it (again, as with a credit card) and then borrow again, as long as you don’t exceed your credit limit.
When the draw period ends, your repayment period begins. You will now have a set amount of time (often 20 years) to pay back the loan. During the repayment period, you cannot withdraw funds from your HELOC and you’ll be responsible for paying back what you borrowed, plus the interest on the loan. Most HELOCs come with a variable interest rate, although some lenders may offer a fixed-rate term on them as well.
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When To Use A Second Mortgage
Should I Choose A Home Equity Loan?
Home equity loans work well for debt consolidation, because you’ll probably have a pretty solid understanding of the exact dollar amount you need to borrow. Home equity loans can also be a good choice when you’re tackling a single renovation or repair project, such as replacing a roof or remodeling a kitchen or bathroom, and need a specific amount of money to pay for it.
Should I Choose A HELOC?
A HELOC may be a better option if you need funds for several ongoing home improvement projects or you’re otherwise unsure exactly how much equity you’ll need to use. Some parents decide to use a second mortgage to fund a child’s college education. While using a second mortgage for tuition payments can carry significant risk, a HELOC would allow you to make payments as you go and use only what you need, versus taking out a lump sum.
Cash-Out Refinance Vs. Second Mortgage: Pros And Cons
Let’s explore the benefits and drawbacks of both cash-out refinances and second mortgages to help you determine which financing option might be best for you.
Pros Of Cash-Out Refinances
- Refinancing could allow you to lock in a lower interest rate. That’s possible if your credit score has improved or mortgage rates have decreased since you closed on your loan.
- You can also change your loan terms. This can be done by refinancing from an adjustable-rate mortgage to a fixed-rate mortgage – or, if you want to pay off your mortgage sooner, you can refinance to a 15-year term. You can also refinance to lengthen your loan term if you’re looking to lower your monthly payments.
- You’ll still only have one monthly mortgage payment. Since refinancing involves replacing your current mortgage with a new loan, when you’re done, you’ll still have just one mortgage payment to make each month.
- Your interest rate may be lower than it would be on a second mortgage. Interest rates on a second mortgage (like a home equity loan or a HELOC) are often higher because the lender is in a secondary position if you default (the lender on the first mortgage gets repaid first).
Cons Of Cash-Out Refinances
- Your loan term may reset. When you replace your first mortgage with a new one, your loan term may reset. If that happens, you could end up paying interest payments longer, adding up to paying more due to the reset loan terms.
- You’ll pay higher closing costs. Closing costs for a cash-out refinance are usually higher than those for a second mortgage. A cash-out refinance may cost 2% – 6% of the total loan amount. So if you refinance a $200,000 loan, say, you may have to pay $4,000 – $12,000 at closing or roll those costs into your loan, which will further increase your monthly payment.
- You could end up with a higher interest rate. If mortgage rates have increased since you closed on your original loan, you may end up paying a higher interest rate, making the mortgage more expensive.
Pros Of Second Mortgages
- You can choose what type of second mortgage to go with. You can receive your funds as a lump sum (home equity loan) or as a revolving line of credit (HELOC) to borrow from and repay as needed, depending on the type you decide to use.
- You may pay fewer closing costs. Some mortgage lenders may even cover the closing costs associated with your home equity loan or HELOC. Even if they don’t, you’ll almost certainly be paying costs on a much smaller loan amount than if you refinanced, so that 2% – 6% of the amount borrowed will be accordingly smaller as well.
- You can preserve your current loan terms. If you’re happy with the interest rate on your primary mortgage loan, taking out a second mortgage rather than refinancing allows you to keep it.
Cons Of Second Mortgages
- You’ll have two mortgage liens. Having two liens on your property can put a significant strain on your budget, as you’ll need to make two separate payments each month. If you struggle to afford them, missing a payment on either increases your risk of foreclosure, since your home acts as the collateral on both loans.
- You’ll likely have a higher interest rate. Because of the added risk that comes with having multiple liens on your property, second mortgages often have higher interest rates than cash-out refinances.
- You won’t be able to improve the terms of your first mortgage. Unlike with a cash-out refinance, you won’t have the chance to lower the interest rate or change the loan term of your primary mortgage.
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How To Choose Between A Cash-Out Refinance And A Second Mortgage
Now that we’ve examined the pros and cons of cash-out refinances and second mortgages, let’s look at some different scenarios to help you decide which best fits your needs.
When To Take Out A HELOC or Home Equity Loan
- You want to avoid high closing costs. Closing costs on second mortgages are lower than those on a cash-out refinance loan. In some cases, your lender may even waive your origination fee and other costs on a second mortgage.
- You don’t want to change your current mortgage terms. A second mortgage is an entirely new and separate mortgage (with its own rates and terms) on your home. That means your primary mortgage rates, terms and monthly payments all remain the same.
- You can choose how you get your cash. When you take out a second loan, you can opt for a lump sum or a line of credit, depending on the best fit for your finances.
When To Get A Cash-Out Refinance
- You want to lock in a lower mortgage rate. If you have good credit, the market is right and you meet your lender’s underwriting standards, you may qualify for a lower interest rate with a cash-out refinance.
- You want only one mortgage payment. Since a cash-out refinance replaces your original mortgage, you won’t need to juggle multiple housing payments each month.
FAQ
In some special cases, such as if you are serving or are a veteran in the U.S. armed forces and aleady have a VA loan, you may be able to qualify for a special type of mortgage called a VA IRRRL refinance, which has no set minimum credit score for qualification. If your primary mortgage is an FHA loan, you could consider applying for an FHA Streamline refinance loan, which similarly often has no minimum credit score (though lenders still might). As always, talk to your mortgage lender about your options.
If you do have to pay closing costs on a second mortgage, you may be able to roll them into the amount you borrow, allowing you to avoid paying them up front at the closing. And in any event, closing costs on a second mortgage are likely to be far less than those on a cash-out refinance with a much larger loan amount.
The Bottom Line: Consider Your Goals To Choose What’s Best
Both a second mortgage and a cash-out refinance will give you access to your home’s equity so you can consolidate debt, pay for a home renovation or accomplish other goals. Your financial situation will determine whether taking out a second mortgage or refinancing an existing one is the best option for you.
Ben Shapiro
Ben Shapiro is an award-winning financial analyst with nearly a decade of experience working in corporate finance in big banks, small-to-medium-size businesses, and mortgage finance. His expertise includes strategic application of macroeconomic analysis, financial data analysis, financial forecasting and strategic scenario planning. For the past four years, he has focused on the mortgage industry, applying economics to forecasting and strategic decision-making at Quicken Loans. Ben earned a bachelor’s degree in business with a minor in economics from California State University, Northridge, graduating cum laude and with honors. He also served as an officer in an allied military for five years, responsible for the welfare of 300 soldiers and eight direct reports before age 25.
