There are several options for accessing the equity in your home for a large lump sum of cash. Two of the more common options are refinancing your mortgage or taking out a home equity loan. Both solutions can help you use your home’s equity for debt consolidation, financing education, home improvement, and almost anything else. There is no single right answer as to which option is best for your situation. The first step is understanding the major differences between these options and the pros and cons of each.
What is a Refinance?
Refinancing a mortgage involves taking out a new home loan to replace the existing one, usually with more favorable terms such as a lower interest rate or a shorter term. There are two popular types of refinances:
Why Choose a Cash-Out Refi?
- Standard refinance. With a standard refinance, also known as a rate-and-term refinance, the only terms that change with the new loan are the mortgage interest rate, the term of the loan, or both. For example, you may refinance a 30-year mortgage into a 15-year loan and/or get the rate reduced from 6% to 4%. Because you do not walk away with cash, you may be able to finance closing costs into the new balance.
- Cash-out refinance. A cash-out refinance is the option that allows you to access your home equity. With this loan solution, you may get a new loan term or a lower interest rate, but the defining feature is the amount you are borrowing increases. As you only owe the original amount still outstanding on your mortgage and closing costs, you can borrow more money against the equity in your home. For example, if you owe $100,000 on your existing loan and your home is now worth $210,000, you can refinance into a new loan at $210,000 and cash out the $110,000 in equity.
A cash-out refinance offers several benefits, especially when compared with a home equity loan:
- A cash-out refinance gives you a single monthly payment.
- The interest rate on a first mortgage (refinance) is usually lower than with a home equity loan
- If interest rates are lower than you are paying now, you can access your equity and lock into a lower rate
There are some drawbacks to this solution, however. The closing costs on a refinance are usually higher than with a home equity loan. Refinancing your mortgage can also cause you to “reset” your loan, which means the term starts over, unless you refinance into a loan with a lower term. For example, if you have 13 years remaining on a 30-year mortgage and refinance into a new 30-year mortgage, your loan now has 30 years left. There is also the potential that you will be unable to refinance into a lower rate. If mortgage rates have gone up since you got your current loan, you may need to lock into a much higher mortgage payment.
What is a Home Equity Loan?
A home equity loan is also known as a second mortgage. With this solution, you can borrow against the equity in your home and receive a lump sum of money that is paid back in fixed monthly installments for a period of time, usually 10 or 15 years. The payment on your home equity loan will be separate from your primary mortgage and it may or may not be from the same lender. As with a cash-out refinance, a home equity loan usually has a fixed interest rate for predictable payments.
Why Choose a Home Equity Loan?
There are several benefits to a home equity loan over a cash-out refinance:
- Closing costs tend to be lower with home equity loans than refinance loans
- You may be unable to get a lower interest rate or better terms on your primary mortgage. In this case, it may make more sense to finance the smaller loan amount (to access equity) with a second mortgage. Taking out a home equity loan of $50,000 at 6% while paying a primary mortgage of $200,000 at 3.75% is more cost-effective than refinancing $250,000 at 6%, as an example.
Despite these pros, remember that a home equity loan is likely to have a higher interest rate than a refinance loan. Don’t assume that borrowing the money on a second loan will protect against foreclosure, either; second mortgage lenders can also foreclose on the home if you default on payments down the road.