Buying a home has its benefits. In addition to being able to try out that funky wallpaper you’ve always wanted, you can tap into your home’s equity. What’s the best way to do that? Let’s look at a cash-out refinance versus a home equity loan.
What is a Cash-Out Refinance?
A cash-out refinance allows you to replace your current mortgage with a new one and you receive cash as a part of the process. How does it work?
It starts with the amount of equity you have in your home. Your equity is the amount of your home that you actually own. You can determine your equity by subtracting the balance of your mortgage from the value of your home.
Let’s say your home is valued at $200,000. You owe $125,000 on your mortgage. That means you have $75,000 in equity ($200,000 – $125,000 = $75,000).
With a cash-out refinance, you take out some of that equity and add that to your mortgage balance. Using the previous example, if you wanted to access $25,000 of your home’s equity, you would work with a lender and borrow $150,000. It would pay off your previous loan balance of $125,000 and you’d receive $25,000 soon after closing.
You still only have a single mortgage payment. You’re just replacing your original mortgage with a new one.
Cash-Out Refinance Requirements
As with any loan, you’ll need to meet the lender’s requirements to qualify. Each lender has its own standards, but in general, you’ll need to meet the following requirements:
- Decent credit score: Your credit score is a 3-digit computer-generated number that sums up your credit history. For a cash-out refinance, lenders typically require a score of 620 or higher.
- Low debt-to-income (DTI) ratio: Lenders want to be sure you have enough income to cover your new mortgage along with other expenses. To determine that, they look at your DTI ratio. This compares your total debt payments (your new mortgage, car payments, credit card minimum payments) with your pre-tax income. If you have $1,500 in monthly debt payments and $4,000 in monthly income, your DTI ratio is 37.5%. You typically need a DTI of 50% or less to qualify for a cash-out refinance, but the lower it is, the better.
- Equity in your home: You also need enough equity in your home to ensure it’s worthwhile to do a cash-out refinance. VA refinances allow you to cash out 100% of your equity, but conventional cash-out refinances require you to leave 15% to 20% of equity. FHA cash-out refinances require you to leave 15% of equity.
Cash-out Refinance Pros and Cons
Is a cash-out refinance right for you? Let’s look at the pros and cons.
- You can use the proceeds from a cash-out refinance for whatever you want. For example, if you’re planning extensive renovations, a cash-out refinance is one way to get those funds. Depending on the work you’re doing, you may also boost your home’s value, which increases your equity.
- Consolidate high-interest debt. Another popular use for cash-out refinances is to pay off high-interest debt. This works best when mortgage rates are low and if you’re committed to not accumulating more high-interest debt.
- Lower your interest rate. A cash-out refinance typically has a lower interest rate than other options for obtaining funds, like a home equity line of credit or personal loan.
- Improve your loan terms. If you were a first-time home buyer, you might not have known what loan options were available. You might have gotten a 15-year mortgage when a 30-year would be a better fit for your goals (or vice versa). You may be able to change and improve your loan terms while you access needed cash.
- Cash-out refinances are secured by your home. Just like your initial mortgage, your cash-out refinance is secured by your home. Your lender could foreclose on your home if you’re unable to keep up with payments. Review the repayment terms of a cash-out refinance to make sure you’re comfortable with the payments.
- Closing costs are still involved. Cash-out refinances come with closing costs, so you want to make sure that you’re taking out enough money to make paying thousands in closing costs worthwhile.
- You get a new mortgage with new terms. When you get a cash-out refinance, you’re essentially starting fresh with a new mortgage. Depending on the terms of your new mortgage, you could have as many as 30 years of payments ahead of you.
The Best Cash-Out Refinance Mortgage Lenders
Which cash-out refinance lender is the best? Here are Benzinga’s picks.
What is a Home Equity Loan?
A home equity loan is a second mortgage, which means it’s secured by your home. You borrow a lump sum that’s based on the equity in your home. You make monthly payments to repay the loan.
You can typically borrow up to 85% of the equity in your home. If you have $75,000 in equity in your home, you could borrow up to $63,750. These loans typically have a fixed interest rate, which means the interest rate and monthly payments don’t change. Lenders offer a variety of terms, so you could repay the loan from 5 years to 20 years or more.
Home Equity Loan Requirements
What are the requirements for a home equity loan? Let’s take a look.
- You need to have enough equity in your home for the loan to make sense. Lenders typically prefer you to have at least 15% to 20% equity in your home when you apply.
- Lenders will also look at your credit score. The exact requirements vary, but you’ll typically need a score of at least 620. The higher your credit score is, the better your interest rate will be.
- Make sure your DTI ratio is adequate. Lenders prefer a DTI ratio of 43% or less for home equity loans.
Home Equity Loan Pros and Cons
What are the advantages and disadvantages of a home equity loan? Here’s what to consider.
- Like a cash-out refinance, a home equity loan can be a good way to fund home renovations and repairs. There are no limitations on how you use the loan funds.
- You can consolidate debt. This product is also a good way to pay off high-interest debt.
- Lower your interest rate. Since a home equity loan is secured by your home, you can typically find competitive interest rates, especially when compared to credit cards and personal loans.
- You risk your home. A home equity loan is a second mortgage. If you’re unable to make payments, your home could be at risk, even if you keep up payments on your primary mortgage.
- You’ll take on another payment. A cash-out refinance replaces 1 mortgage with another. A home equity loan is an additional loan payment, which means it’s 1 more payment to remember and manage every month. If you’re considering a home equity loan, make sure you can keep up with the costs.
- Closing costs are also part of the deal. A home equity loan also has closing costs. These costs are typically 2% to 5% of the loan amount, so it can be a significant amount of money.
The Best Home Equity Loan Mortgage Lenders
To find the best home equity loan, it’s best to contact multiple lenders. Here are Benzinga’s top picks.
securely through Figure HELOC’s website
* Our APRs can be as low as 3.00% for the most qualified applicants and will be higher for other applicants, depending on credit profile and the state where the property is located. For example, for a borrower with a CLTV of 45% and a credit score of 800 who is eligible for and chooses to pay a 4.99% origination fee in exchange for a reduced APR, a five-year Figure Home Equity Line with an initial draw amount of $50,000 would have a fixed annual percentage rate (APR) of 3.00%. The total loan amount would be $52,495. Alternatively, a borrower with the same credit profile who pays a 3% origination fee would have an APR of 4.00% and a total loan amount of $51,500. Your actual rate will depend on many factors such as your credit, combined loan to value ratio, loan term, occupancy status, and whether you are eligible for and choose to pay an origination fee in exchange for a lower rate. Payment of origination fees in exchange for a reduced APR is not available in all states. In addition to paying the origination fee in exchange for a reduced rate, the advertised rates include a combined discount of 0.50% for opting into a credit union membership (0.25%) and enrolling in autopay (0.25%). APRs for home equity lines of credit do not include costs other than interest. Property insurance is required as a condition of the loan and flood insurance may be required if your property is located in a flood zone.
securely through Rocket Mortgage’s website
Which Option is Right for Me?
Which home equity product is right for you? That depends on your situation and your personal preferences. If you only want to manage 1 payment or want to secure better mortgage terms, a cash-out refinance might be best.
If you want to keep your loan separate from your primary mortgage, a home equity loan might be best. For example, if you have a low interest rate on your primary mortgage or have been paying on it for decades, it may be best to leave that mortgage alone and take out a home equity loan.
If you’re unsure about which option is best, contact lenders. Many online mortgage lenders offer refinances and home equity products, as do local brick-and-mortar ones. As you compare lenders and options, consider:
Interest Rates and Fees
The interest rate is a good starting point, but also look closely at the fees and any discounts. Make sure you’re comparing apples to apples. In other words, compare a home equity loan quote from 1 lender with a home equity loan quote from another. Comparing a home equity loan quote with a cash-out refinance isn’t as helpful.
Does the lender answer your questions quickly? Is the lender willing to educate you about your loan options? Do you feel valued as a customer? Look for a lender that offers excellent service.
What kind of reviews does the lender have? Does it have complaints with the Better Business Bureau? Do you know anyone else who’s worked with the lender? Look for a lender with an outstanding reputation.
Keep in mind that there is an element of risk when you tap into your home’s equity. For example, if your home’s value drops, you could end up owing more than your home is worth. It still might be worthwhile to move forward with the transaction, but keep in mind the pros and cons.
Frequently Asked Questions
You do not lose equity when refinancing a home. Equity is the difference between what you owe on a home and what it’s worth, and the those values don’t change when you refinance.
A cash out refinance is when you refinance your mortgage and take out cash in exchange for a larger mortgage.
While interest rates on a home equity loan are higher than those on a cash out refinance, the closing costs are generally lower.