Cash-out refinance vs. home equity loan

The years you spend faithfully making mortgage payments earn you equity over time, turning your home into a substantial asset against which you can borrow significant amounts of money. Two of the most popular options for accessing your home’s equity are cash-out refinances and home equity loans.

The two seem pretty similar at first glance, but they have a few distinct traits that make them suitable for different types of homeowners. A cash-out refi replaces your existing mortgage, while a home equity loan is a second mortgage. Read more to see which might be best for you.

What is a cash-out refinance?

A cash-out refinance is a type of refinancing loan that lets you convert some of your equity into cash. It involves taking out a new loan larger than your existing balance to pay off the first mortgage. The remaining cash is yours to use on whatever you’d like. Many homeowners use these funds to make home improvements or consolidate debt. By cashing out this way, you shrink your equity — but you free up funds to use elsewhere.

With a cash-out refi, you’ll have to pay closing costs again (usually 2% to 5% of the loan).

Qualifications

As a general rule, you need at least 20% equity in your home to get a cash-out refinance. Most lenders won’t let you take out one of these loans if the loan-to-value ratio is above 80% (determined by an appraiser).

Beyond that, exact qualifications for a cash-out refinance vary by lender. However, there are a few minimum guidelines. Most lenders will want to see a credit score of at least 620 and a debt-to-income (DTI) ratio less than or equal to 43%.

Additionally, you’ll have to pay closing costs of about 2% to 5% (similar to getting a mortgage loan).

Repayment terms

Cash-out refinancing loans are effectively new mortgages. As a result, you can generally pick a loan term of 15 or 30 years.

A shorter loan term generally comes with a higher monthly payment but lower interest rate, while a longer loan term will cut your monthly payment but increase your interest rate — meaning you'll pay more in interest over the life of the loan.

Tax deductions

The cash portion of your cash-out refinance is tax-free. It’s part of a loan you must repay, so the IRS doesn’t view it as income. Normally, the IRS allows you to deduct interest on any home loan used to build on or substantially improve a home.

For example, imagine you get a $100,000 cash-out refinancing loan. $75,000 is used to pay off your existing loan, and $25,000 is your cash-out amount. If you use that $25,000 to make capital improvements to your home, the interest could be deductible, provided you meet all IRS requirements.

Dealing with tax deductions on cash-out refinancing loans can get a bit complicated, so it's a good idea to work with a tax professional to ensure you deduct the correct amount.

What can you use a cash-out refinance for?

You can use a cash-out refinancing loan for almost anything. Many people use this kind of refinancing to make home improvements.

Here are some other potential uses for your cash-out refinance:

• Consolidating and refinancing high-interest debt
• Paying medical bills
• Covering emergency expenses
• Funding education
• Making a down payment on a second home or rental property

What is a home equity loan?

A home equity loan lets you borrow a lump sum of cash against the equity you have in your home. Because a home equity loan uses your home as collateral and doesn’t replace your original mortgage, it’s considered a second mortgage.

Qualifications

Most home equity lenders prefer a borrower to have at least 15% to 20% equity in their home.

Home equity loans have income and credit qualifications, like purchase mortgages. You also need enough equity in your home. Lenders require you to have at least 15% to 20% equity in your home. You can calculate your home equity using two key figures: the balance on your mortgage and the current value of your home.

Generally, you’ll need a credit score of at least 620 and a DTI ratio no larger than 43%. The credit score and income requirements may vary based on the amount of equity and debt you have.

Repayment terms

Home equity loans require you to repay in fixed monthly payments that consist of principal and interest. Repayment term lengths are flexible, ranging from five to 30 years, depending on the lender.

Remember: Shorter term lengths will come with higher monthly payments but lower interest rates. Longer term lengths reduce your monthly payments but include a higher rate.

Tax deductions

Home equity loans are not considered income by the IRS since you must repay the bank. As a result, the IRS does not tax your loan proceeds. You can deduct the interest on a home equity loan to the extent the funds are used to build on or improve your existing home.

For example, imagine you get a $100,000 home equity loan. If you make renovations using that $100,000, you could potentially deduct the interest on the loan.

However, say you instead put $20,000 of that toward a home improvement project, while the remaining $80,000 is used to fund your child’s college, establish an emergency fund and buy a new car. You’d only be able to deduct interest on $20,000.

Just as with cash-out refis, the rules for deducting home equity loan interest can be complex. Consult with a tax advisor to make sure you deduct the correct amount.

What can you use a home equity loan for?

As with a cash-out refinance, you can use your home equity loan for virtually any purpose. Some common uses include:

• Consolidating and refinancing high-interest debt
• Making home improvements
• Saving for home repairs
• Creating an emergency fund
• Saving for a child’s college tuition

Home equity loan vs. HELOC

Both home equity loans and home equity lines of credit (HELOCs) let you convert your equity into a loan. The main differences are in when you receive the funds and how you pay them back.

A home equity loan is paid out in a lump sum, while a HELOC provides access to a revolving line of credit.

With a home equity loan, you receive all the money as a lump sum. You then repay it in fixed payments of principal and interest. With a HELOC, you gain instant access to a specific amount of funds, which you can borrow at any time during the draw period, which might be five to 15 years. During the draw period, you only make interest payments (though you can pay off principal and get funds back on your credit line). Once the draw period ends and the repayment starts, you begin making payments that include principal. The repayment period lasts 10 to 20 years.

HELOCs offer more flexibility than home equity loans because you only pay interest on the amount of money you draw. However, HELOCs have an adjustable interest rate, which can make payments unpredictable; home equity loans have a fixed interest rate, along with fixed monthly payments.

Bottom line: Is a cash-out refi or a home equity loan right for you?

Mortgage payments aren’t very fun to think about. But they do pay off — you can convert that equity into cash with a cash-out refinance or use it to take out a home equity loan.

Cash-out refinances are first loans that replace your mortgage, so the interest rate tends to be lower than on a home equity loan. However, home equity loans tend to have lower closing costs, making them more affordable upfront. Ultimately, you need to weigh your financial goals, your current situation and your plans for the funds before making a decision. This will help you maximize your hard-earned home equity.

As you research lenders to find the right option for you, beware of bait-and-switch tactics. A few of our reviewers, including one from New York and one from Virginia, have reported company representatives trying to rope them into a refinance when they inquired about a home equity loan.