Some people purchase a home for the sole purpose of building equity and increasing their net worth. The problem with this approach is that the cash in our homes isn’t liquid, and if we want to get our hands on the money, we may have to sell the property.
Fortunately, selling your home isn’t the only way to tap your equity. You also have the option of getting acash-out refinance or a home equity loan. Although both achieve a similar purpose, one choice may be a better fit for your circumstances.
Therefore, it’s important to recognize the differences between a refinance and a home equity loan.
What Is a Mortgage Refinance?
Refinancing is the process of applying for a new mortgage to replace a current mortgage. There are different types of refinancing. Some people only consider a rate and term refinance, where the primary purpose is lowering their mortgage rate and/or modifying their mortgage term. But others apply for a cash-our refinance and borrow money from their equity.
A cash-out refinance also gives borrowers the opportunity to enjoy a cheaper rate and lengthen or shorten their mortgage term. The main difference is that these borrowers also receive a lump sum at closing which can be used for many purposes including home renovations, debt consolidation, wedding expenses, college tuition, etc.
What Is a Home Equity Loan?
A home equity loan is another option for getting your hands on your equity. You have two options: a home equity loan or a home equity line of credit (HELOC).
Funds with a home equity loan are disbursed in the same manner as a cash-out refinance, meaning you’ll also receive a lump sum from the lender. But in the case of a home equity line of credit, you have access to a revolving credit line up to a certain amount, and you can withdraw money from the account as-needed.
Refinance vs. Home Equity
When weighing the pros and cons of a cash-out refinance or a home equity loan, you have to consider whether you prefer one mortgage loan or multiple mortgage loans.
There is a convenience factor with a cash-out refinance because the amount borrowed from your equity is wrapped into the new mortgage loan. You’ll maintain a first mortgage on the property and you’ll only have to manage one mortgage payment. Keep in mind, however, that since you're borrowing from your equity and adding this amount to your mortgage, your new mortgage balance will be higher than your previous mortgage balance. Therefore, your monthly payment may be higher or remain the same, depending on your new mortgage rate and term.
A home equity loan and a home equity line of credit do not replace your first mortgage, but instead creates a second mortgage. Like a cash-out refi, you can typically get a home equity loan or line of credit up to 80% of your equity. However, the amount borrowed from a home equity loan or HELOC isn’t merged with your first mortgage. You repay these separate from your first mortgage. So rather than have one home loan payment a month, you'll have two home loan payments: a first mortgage and a second mortgage.
It's important to note that closing costs are common with both refinancing and a home equity loan/line of credit. Closing costs are ordinarily higher with refinancing (between 2% to 5% of the mortgage balance), whereas closing costs with a home equity loan or line of credit can be as little as a few hundred dollars, depending on how much you borrow.
The upside is that a cash-out refinance will likely have a lower interest rate than the rate on a home equity loan or a home equity line of credit. But regardless of whether you choose a cash-out refi or a home equity loan, you'll lose equity with either choice. If your home’s equity is $100,000 and you pull $60,000 from the equity with a cash-out refi or a home equity loan, you’re left with only $40,000. And if you sell the home before paying down your new mortgage balance, or paying back a home equity loan or line of credit, you'll walk away with less profit.
Which Is the Right Choice?
When choosing between a cash-out refinancing and a home equity loan/HELOC, the decision should be based on your mortgage needs. If you need to borrow cash from your equity, and you also seek a lower mortgage rate, a cash-out refinance allows you to accomplish both objectives. You'll pay more in closing costs with this option and your mortgage balance will increase, but a lower mortgage rate can reduce your housing expense, and it might improve your financial outlook.
On the other hand, if you only need cash and you don't want to modify your current mortgage rate and term, a home equity loan or line of credit is the better fit. You can borrow exactly what you need from your equity without going through the hassle of acquiring a new first mortgage.