Cash-out refinance vs. home equity loan: Which to pick

If you’re looking for a way to tap your home equity, cash-out refinances and home equity loans are two of your options. Both allow you to turn home equity into cash for home improvements, debt consolidation, or other expenses. However, the process for obtaining them — not to mention paying them off — is slightly different.

What is a cash-out refinance?

A cash-out refinance replaces your existing mortgage loan with a new one. Your new loan will be larger than your current one, and you’ll take the difference between the two balances in cash.

The requirements for a cash-out refinance depend on your mortgage lender and loan product, but, generally, to qualify for a conventional loan you’ll need a minimum of:

• Credit score: 640 to 700
• Debt-to-income ratio: 36% to 45%
• Equity: 20%

What is a home equity loan?

A home equity loan is a type of second mortgage. These are loans against your equity in the home, and once you close, you’ll get the balance of the loan in cash. You’ll then pay it back (in addition to your existing mortgage) month after month until you’ve paid in full.

Again, the minimum requirements for a home equity loan will vary by lender, but here’s what you can generally expect:

• Credit score: 620
• Debt-to-income ratio: 43%
• Equity: 15 to 20%

Learn More: Personal loan or home equity loan: Which is better?

How cash-out refinancing and home equity loans are similar

Both cash-out refinances and home equity loans let you turn your home’s equity into cash.

Aside from this, they also have the following things in common:

• You can use the proceeds however you like. There’s no limit to how you can spend your money once you’ve closed on the loan.
• You’re paid immediately. You’ll receive a lump sum payment no matter which product you choose to go with.
• You’ll pay the loan off monthly. In both cases, you’ll pay your loan off monthly, just as you do your current mortgage.

How cash-out refinancing and home equity loans are different

The main difference between these two options is that cash-out refinancing requires just one monthly payment, while home equity loans require two (your existing mortgage plus the home equity loan payment).

Here are some other ways the two products differ:

• Interest rates: Cash-out refinances can have lower interest rates than home equity loans.
• Closing costs: With home equity loans, your lender will usually pay many of your closing costs. This is not the case with cash-out refinances.
• Impact on original loan: A cash-out refinance fully replaces your existing mortgage loan and its monthly payment. A home equity loan is an additional mortgage on top of your current one.

When to choose a cash-out refinance

A cash-out refinance might be your preferred option if:

• You want just one single monthly payment. If you’re not able to manage a second monthly payment in addition to your primary mortgage, a cash-out refinance may be your best bet.
• You want a lower interest rate. Cash-out refinances generally come with lower interest rates than home equity loans. If interest rates are lower than what’s on your current loan, you’ll save even more.
• You’re looking to consolidate debt. Since cash-out refinances come with low interest rates, they can be good for consolidating higher-interest debts like credit cards and personal loans. You’d use the cash portion of your loan to pay off those balances, and then enjoy the much lower interest rate on your mortgage instead.

When to choose a home equity loan

Generally, a home equity loan will work better for you if:

• You’re happy with the terms on your current mortgage. If a cash-out refinance would mean getting an interest rate much higher than your current one, a home equity loan may be a better option.
• You think you’ll sell the home in the near-term. Since refinances come with more closing costs, they might not make sense if you plan to sell soon (you may not recoup the expenses before then). In this scenario, a home equity loan may be best.
• You only need a small amount. Because of the higher closing costs on refinances, home equity loans are also better for smaller expenses — especially if you know you can pay it off quickly.

An alternative to cash-out refinancing and home equity loans

HELOCs — or home equity lines of credit — are a third way to tap your home equity. These are similar to home equity loans in that they’re borrowed in addition to your existing mortgage. The difference is that your funds aren’t distributed to you in a lump sum.

Instead, HELOCs function more like credit cards. You can draw funds from your line of credit as needed, usually over a period of 10 years. Once that period expires, you’ll start repaying the money spent, plus interest.

A HELOC is typically best if:

• You’re not sure how much cash you need or you want to use it for a variety of expenses. HELOCs let you withdraw cash as you need it — much like a bank account or credit card.
• You’re comfortable with a variable interest rate. Unlike refinances and home equity loans, HELOCs usually come with variable rates that can rise over time.
• You don’t want to start paying off the loan right away. You won’t start paying down the balance until your draw period expires — usually around 10 years.

If you’re deciding between a home equity loan or HELOC vs. a cash-out refinance, be sure to consider your goals, budget, and unique financial situation. All three options can be smart ways to access your home equity.

Keep Reading: Home equity loan vs. HELOC: Which is better?