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Cash-Out Refinance vs. Home Equity Loan: Which Is the Better Fit?

September 30, 2022
Cash-Out Refinance vs. Home Equity Loan: Which Is the Better Fit?

What is your strategy when it comes to making major home renovations or repairs? Maybe — like many homeowners — you identify what needs to be done, then painstakingly save until you’ve squirreled away enough to tackle your project. Or maybe you pay down a credit card (or two) and charge the repairs to your cards instead. While either of these methods is an effective way to finance your home improvement projects, they bring negatives with them as well. 

Saving up takes time, and while a swimming pool can wait, a new air conditioner in the middle of July cannot. A credit card, on the other hand, provides instant gratification at the expense of sky-high interest rates topping 20% on average.1 It’s because of these downsides that most homeowners will consider alternatives — participating in the cash-out refinance vs. home equity loan debate. To help homeowners choose the right financial tool for them, Truehold has outlined everything you need to know to make an informed decision between a cash-out refinance and a home equity loan. 

What Are the Types of Refinancing? 

Refinancing, when done at an opportune time, such as when interest rates are lower or when the borrower’s credit standings have improved, can help homeowners save thousands on their mortgages. It should come as no surprise, then, that refinancing is a common occurrence — with nearly 25% of American homeowners having refinanced in 2021 alone.2 Refinancing can also be an effective strategy for accessing home equity, making it a popular choice among homeowners looking to free up some cash. There’s no one-size-fits-all strategy when it comes to refinancing, however, and the different types of refinancing will have different impacts on borrowers. 

Rate-and-Term Refinancing

This refinancing strategy is the most commonly-used tool, as it sees homeowners utilize the mortgage refinancing process to lower their interest rates and potentially pay off their home sooner than expected. Typically, a rate-and-term refinance is done during times of lower economic activity (and therefore lower interest rates), but borrowers who have rehabilitated their credit since taking out the original loan can also benefit from this strategy. 

Cash-In Refinancing

Whereas a rate-and-term refinance is a response to improved interest rates for borrowers, a cash-in refinance can be done at any time. Through a cash-in refinance, homeowners make a large payment toward their home loan to decrease their principal — altering their loan term and rate in the process. Considering many lenders require 20% equity to refinance, a cash-in refinance can be a tool to help borrowers achieve that benchmark and seize the benefits. 

Cash-Out Refinancing

Through a downpayment and monthly payments, homeowners begin to accrue home equity — and a cash-out refinance is a way for borrowers to take out some of this equity in cash. Cash-out refinancing at the right time can also help borrowers attain better rates, but this tool is especially valuable to those looking to free up equity to put toward larger purchases. 

When Should You Refinance Your Home? 

As mentioned above, the primary goal of mortgage refinancing is for borrowers to leverage their current situation to lower the required monthly mortgage payment rates and payments on their home loan. However, there are a number of situations where refinancing your home could be the right decision. Before we explore a cash-out refinance vs. home equity loan, let’s look at some common reasons to refinance. 

When Average Interest Rates Dip

One of the most common times homeowners refinance is when national interest rate averages dip below where they were when the home loan was initially taken out. Assuming homeowners have accrued enough equity to pursue a refinance and have a strong enough credit profile (generally 20% and above a 620 score for most lenders,) lower interest rates are a great reason to leverage a rate-and-term refinance.  

When Your Credit or Financial Standing Improves

When homeowners with below-average credit or bad credit apply for home loans, they may be seen by a lender as being high risk.3 Some lenders will simply deny these borrowers, but others will trade approval for higher interest or refinance rates. As these borrowers pay down their loan and accrue equity through their loan term, their debt-to-asset ratio will likely decrease — potentially raising their credit score in the process. Borrowers can then leverage a higher credit score (in addition to lower average interest rates) to refinance their home loan and lower their refinance rates. 

When You Want to Access Your Home Equity

Another situation when homeowners should consider refinancing is when they’re looking to access their home equity. Through a cash-out refinance — which we’ll explain in greater detail below — borrowers take out a new home loan and tap into a percentage of their existing equity. This cash is not taxed and can house the same benefits of a personal loan or maxing out a credit card without the punishing interest rates. Refinancing can serve multiple purposes, however, and homeowners looking to access their home equity can lower their rates in the process. 

What Are the Benefits (and Disadvantages) of Refinancing? 

Refinancing can be a great tool for homeowners looking to take advantage of changing real estate markets, improved property value, or accrued equity, but it’s not for every homeowner. For the right borrower, refinancing can be a way for them to pay down their home loan much faster — as much as 15 years faster, actually — while paying a lower interest rate, and therefore a lower monthly payment. Borrowers can also refinance and make the switch to a fixed-rate mortgage payment if they’re currently locked in at a variable rate, making mortgage payments far more predictable. 

Of course, refinancing your home loan is (unfortunately) not as simple as waving a magic wand. This process can be complicated, and will involve applying for a new loan in addition to getting an appraisal and gathering documentation. It can also be pricey, and the real estate closing costs (usually 2-6% of the mortgage amount) affiliated with refinancing can partially negate your savings — or eat into your equity in the event of a cash-out refinance.4 If refinancing your home doesn’t sound like the best option for you, but you still want to build equity in your home, read up on how to get equity out of your home without refinancing to see what options are available to you.

What Is a Cash-Out Refinance? 

For homeowners less concerned with lowering their monthly rate and more concerned with freeing up home equity, a cash-out refinance can be a valuable financial tool. Here’s how it works: When you’ve accrued over 20% equity in your home, or when your home’s value increases, you swap your current mortgage payment for a new one — which is for a larger amount than what you currently owe on your home. You can then access the difference between the existing mortgage amount and the refinance loan amount in cash, and apply that difference in loan amount toward just about anything you can think of. 

Let’s say a borrower’s home is worth $400,000, and they currently owe half of that ($200,000) on their mortgage. Minus the 20% equity which must remain in the home — $80,000 — the borrower can potentially access $120,000 in the event that they’re approved for a larger loan. Homeowners that choose to reinvest this equity into their home in the form of renovations, repairs, or other value-adding features can then raise their home’s value even more, thus broadening the gap between what they owe and what their home is now worth. If you’re still wondering how to build equity in a home, make sure to read up on the topic to see what you can do to increase your home’s value in the market.

Pros and Cons of a Cash-Out Refinance 

There are countless benefits to a cash-out refinance, but, like any other type of refinancing, a cash-out refinance is not for every homeowner. 

Pros:

  • In addition to tapping into their home equity, this tool may allow homeowners to take advantage of better national average interest rates and therefore pay less in interest.
  • Applying equity toward increasing the home’s value, investments, or paying down other higher interest loans can help borrowers properly leverage their debt.
  • Equity used toward major home improvements may be eligible for a tax break, though this isn’t a guarantee. 

Cons:

  • Less disciplined borrowers may find themselves squandering their equity and massively extending their loan repayment period. 
  • Overextending yourself can put your home at risk of foreclosure in the event that the home’s value drops. 
  • The closing costs affiliated with a cash-out refinance can erode the total cash amount. 

Though the benefits of a cash-out refinance may be enticing, there are other ways to access home equity that may be more beneficial to some borrowers — with a home equity loan being one of them. 

What Is a Home Equity Loan? 

So, what is a home equity loan? Like a cash-out refinance, a home equity loan option is a way for homeowners to access the home equity they have accrued and apply it toward their expenses. Unlike a cash-out refinance, a home equity loan does not present an opportunity for homeowners to adjust their interest rates. Instead of replacing the existing loan, as is the case in a cash-out refinance, a home equity loan is a second mortgage. This means that when it comes time to repay your home equity loan, you’ll have a fixed-rate monthly payment in addition to your original mortgage. 

The advantages of a cash-out refinance will likely exceed those of a home equity loan for many borrowers, but there are instances where a home equity loan becomes the better option. When interest rates have climbed higher than when the original home loan was approved, borrowers looking to cash out their equity via a cash-out refinance will have to sacrifice their lower rate. With a home equity loan, however, they can almost instantly access their equity without adjusting the terms of their home loan. 

Pros and Cons of a Home Equity Loan

A home equity loan brings with it far more limitations than a cash-out refinance, but it is not without its unique benefits, which may appeal to some borrowers.  

Pros

  • Allows borrowers to access a portion of their equity without adjusting the terms of their home loan. 
  • Closing costs affiliated with a home equity loan are generally much lower than those of a cash-out refinance. 

Cons

  • Does not allow borrowers to capitalize on improved average interest rates. 
  • Interest rates will likely be higher than those of a cash-out refinance. 
  • Presents the same risks as a cash-out refinance, and will require a great deal of discipline. 
  • None of the tax advantages found in a cash-out refinance. 

Make the Right Decision for Your Financial Future

While a cash-out refinance will likely be the right choice for most borrowers, there are certain circumstances where a home equity loan can be a great financial tool. Ultimately, when it comes to the argument of a cash-out refinance vs. home equity loan, the winner will come down to your specific needs and situation. 

You may even find that our sale leaseback option is for you. If you’re looking for home equity, a residential leaseback agreement can help you unlock just that –– without the hassle. 

While we have given you much of the information needed to make the right decision for your financial future, Truehold is also here if you need more guidance — or want to explore other options with our team of advisors. 

Sources:

1. LendingTree. Average Credit Card Interest Rate in America Today. https://www.lendingtree.com/credit-cards/average-credit-card-interest-rate-in-america/  

2. The Ascent. Almost 25% of Homeowners Refinanced in 2021. Is It Too Late for You to Do the Same? https://www.fool.com/the-ascent/mortgages/articles/almost-25-of-homeowners-refinanced-in-2021-is-it-too-late-for-you-to-do-the-same/  

3. Rocket Mortgage. What Credit Score Do You Need To Buy A House? https://www.rocketmortgage.com/learn/what-credit-score-is-needed-to-buy-a-house 

4. LendingTree. Understanding Mortgage Refinance Closing Costs.https://www.lendingtree.com/home/refinance/mortgage-refinance-closing-costs/

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