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If you are looking to access some cash from the value of your home, you have two types of loans to consider. A home equity loan is a second loan on your residence that allows you to borrow against the equity you have in your home.
A cash-out refinance loan, on the other hand, lets you take out a new first mortgage for an amount greater than what you currently owe on your existing mortgage.
The lender gives you the difference between the amount of the new loan and the original mortgage as cash that you can use for other expenses.
If you’re not sure which choice is better for you, read on for a closer look at the differences between the two.
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Cash-Out Refinance Loans
Since a cash-out refinance loan is a new first mortgage, you’ll have to go through a process that is similar to that of your existing mortgage. You can fill out an application online or in person at a local branch office. The lender will check your credit history and the current value of the property. After completing the application, you will need to provide documentation of all sources of income as well as all outstanding debts.
In general, it is easier to qualify for a cash-out refinance mortgage than it is for a home equity loan. The cash-out refinance loan poses less risk from the lender’s perspective because they have the first and only claim to the property if you default on the loan. Borrowers can usually choose between a fixed interest rate and an adjustable interest rate. Lenders offer maturities of up to 30 years.
Home Equity Loans
The application process for a home equity loan is fairly similar to that of the cash-out refinance loan. The lender will check your credit history and the value of the property. You’ll also need to provide documentation about the income sources and debts included in your loan application.
Qualifying for a home equity loan is a little more difficult than qualifying for a cash-out refinance loan. From the lender’s perspective, the home equity loan poses a greater risk. A home equity loan is a second claim against the collateral property. So, if you default on your home equity loan, the lender can foreclose against the property but only receives the funds left over after paying the first mortgage claim.
Interest rates on home equity loans are slightly higher than they are on first mortgages because the loan is a second lien against the property. Home equity loans usually have fixed interest rates. Lenders offer terms of up to 15 years.
Cash-Out Refinance vs. Home Equity Loan: Which is Better?
There are typically origination fees and closing costs associated with the cash-out refinance loan. So, you’ll need to factor those into your decision. In exchange for the up-front cost of refinancing, however, borrowers will likely benefit from a lower interest rate and longer maturity. That means the out-of-pocket monthly payment expenses will be lower with the cash-out refinance loan than they will be on the home equity loan.
As a result, the cash-out refinance loan is generally the better option for borrowers who have a long-term financing need. The interest you pay each year on the mortgage is tax deductible.
Most lenders don’t charge borrowers application or origination fees for home equity loans. The higher interest rates and shorter maturity, however, make the monthly cost of a home equity loan more expensive compared to the cash-out refinance loan.
For borrowers with relatively short-term cash needs, the home equity loan is typically the better option. The upfront cost of the cash-out refinance loan outweighs the additional monthly expense of the home equity loan in the short run. Annual interest payments on a home equity loan are also tax deductible under certain circumstances where the borrower uses the proceeds for major home improvements.
Crunching the Numbers: An Example
Let’s start by looking at a home equity loan. Assume you are borrowing $30,000 for home renovation projects and get a home equity loan at 7 percent for 15 years. The monthly payments for this loan are $270.
Now, consider a situation where you refinance your existing mortgage with a cash-out refinance loan in order to get the $30,000 in cash. To keep things simple, assume that you are refinancing at the same interest rate you currently have on your mortgage.
In reality, you may also save money if you refinance into a lower interest rate than you currently have. For this example, however, you want to look at the incremental borrowing cost on only the $30,000. If you take out a new 30-year mortgage at 5.5 percent, the portion of your monthly payment being attributed to the $30,000 is $170. So, the monthly obligation is $100 less for the cash-out refinance loan.
The cash-out refinance loan, however, also has origination costs and title fees. Closing costs can range from 3 percent to 6 percent of the loan amount. If you have $200,000 outstanding on your mortgage, those costs can range from $6,000 to $12,000.
A simple breakeven calculation shows that if closing costs are $6,000 and you save $100 per month by refinancing, it will take you a minimum of 60 months in order to save the amount of the closing costs. You would have to plan to be in the home for more than five years in order for the cash-out refinance to make sense.
If your mortgage balance and closing costs are higher, it will take even longer to reach the breakeven point. So borrowers who may sell their home within a few years might want to choose the home equity loan over the cash-out refinance loan.
Author: Kimberly Goodwin, PhD