As a homeowner, there may come a point when you want to use the equity in your home to access cash. Should the time come, it’s important to understand the similarities and differences between a cash out refinance vs. a home equity loan.
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With various pros and cons of both options, it’s imperative to carefully consider the finer details before heading down either path. This will ensure that you make an informed decision that you’re happy with over the long run.
What is a Cash Out Refinance?
There are two primary aspects of a cash out refinance:
- Your new loan pays off your existing mortgage
- The difference between your balance and the amount you borrow is returned to you in the form of cash.
In the end, you’re left with one mortgage payment and cash you can use for things such as home improvement projects, educational expenses, or to pay off debt, among other things.
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What is a Home Equity Loan?
A home equity loan is exactly what it sounds like. You use the equity in your home to borrow a lump sum of money that’s repaid at a fixed rate over a predetermined term.
Unlike a cash out refinance, a home equity loan is a second mortgage. In other words, you’ll continue to pay your primary mortgage alongside your home equity loan. The only exception is if your home is paid off.
Similarities Between a Cash Out Refinance and Home Equity Loan
No matter if you choose a cash out refinance or home equity loan, you need equity in your property to qualify. Other similarities between these two financial products include:
- You can’t take 100% of the equity from your home: With most lenders, you’re required to have an after-transaction loan-to-value ratio of 85%-90%. This is meant to protect both you and the lender.
- You receive your funds immediately: With either option, you end up with a lump sum of money as soon as you close on your loan. You then have the right to use the funds at your discretion. It’s best to have a plan for how you’ll use the money before applying for a loan.
- Your home is your collateral: This is serious, as failure to pay could result in foreclosure.
Differences Between a Cash Out Refinance and Home Equity Loan
Just as there are many similarities between a cash out refinance vs. home equity loan, there are a handful of differences. Here are some of the most prominent:
- First loan vs. second loan: A cash out refinance is a first loan. With it, you pay off your existing mortgage in exchange for a new one. But with a home equity loan, you’re left with two loans.
- Cash out refinances have lower interest rates: First loans always have better interest rates than second loans. This is because they’re paid first in the event of a foreclosure, bankruptcy, or any other type of judgment.
- Cash out refinances have higher closing costs: A refinance is a new mortgage, so you’ll have all the closing costs associated with this type of loan. Since a home equity loan is a second mortgage, closing costs are lower. This also makes the closing process less complex.
What About the Loan Term?
In addition to the interest rate associated with a cash out refinance or home equity loan, you should also pay close attention to the loan term.
As a first mortgage, a cash out refinance has traditional loan terms such as 10, 15, 25, and 30 years. The longer the term, the lower your monthly payment. Conversely, a longer term also means that you’ll pay more in interest.
Note: a shorter term allows you to secure the most competitive interest rate.
Home equity loans generally have a shorter term, starting at five years. However, depending on the lender, you may be able to stretch the term to as long as 30 years.
Note: a home equity loan is different from a home equity line of credit (HELOC). With a loan, you receive the funds upfront and begin to repay them immediately. But with a HELOC, you can draw from a line of credit as needed. You only have to repay what you use.
How Do You Receive Your Funds?
It doesn’t matter why you’re choosing to refinance your mortgage or apply for a home equity loan, you want to know how you’ll receive the funds. This helps you plan your next move.
- Cash out refinance: You receive a lump sum of cash when you close on your new loan. The loan is first used to pay off your existing mortgage, along with any closing costs such as home insurance and real estate taxes. The remaining funds are yours to use.
- Home equity loan: Funds are provided to you directly at closing. Since you’re not paying off your first mortgage, all the funds from the loan belong to you.
With either option, you can opt to receive your funds via bank wire or check. Most people find it safe and convenient to receive their funds via bank wire, as they don’t have the responsibility of depositing a check.
Questions for Your Lender
While you’re sure to have specific questions for your lender, here are some basic inquiries to kick off your conversation:
- What are the eligibility requirements for a cash out refinance and home equity loan?
- How long will it take to complete an application?
- How long will it be before I can close on the loan?
- What terms do you offer for cash out refinances and home equity loans?
- What are the current interest rates for cash out refinances and home equity loans?
You’ll soon find that every lender you speak with has different answers to these questions.
Cash Out Refinance vs. Home Equity Loan Summary
With this information, you should have a clear vision as to whether you should refinance your mortgage or apply for a home equity loan.
If you’re ready to take action, My Perfect Mortgage can help you find the loan product that’s best for you, your home, and your financial circumstances.