One of the major financial advantages of homeownership is the ability to build equity over time. As you pay down your mortgage and your home’s value increases, you accumulate equity. This is the difference between your home’s value and what you still owe on your mortgage. Equity can be a powerful financial tool, especially when you need access to cash for things like home improvement projects, debt consolidation, major purchases, emergencies, medical costs, or educational expenses.
Two common options for tapping into your home’s equity are home equity loans and cash-out refinances. Let’s take a look at the potential pros and cons of each:
Benefits of a Home Equity Loan:
Benefits of Cash-Out Refinancing:
When weighing the pros and cons of a home equity loan and a cash-out refinance, keep the following things in mind:
Two common options for tapping into your home’s equity are home equity loans and cash-out refinances. Let’s take a look at the potential pros and cons of each:
Home Equity Loans
A home equity loan is essentially a second mortgage on your home. It allows you to borrow a lump sum of money, secured by the equity in your home. You repay the loan in fixed monthly installments over a set term, typically with a fixed interest rate.Benefits of a Home Equity Loan:
- The ability to keep your current mortgage. If you already have a mortgage with a low interest rate, a home equity loan allows you to preserve that favorable rate. Instead of refinancing your entire mortgage and potentially ending up with a higher rate, you can leave your original loan untouched and simply add a second loan for the amount you need.
- Fixed interest rate. Home equity loans typically come with a fixed interest rate, so your monthly payments will be consistent over the life of the loan. This predictability can be a major benefit for budgeting and financial planning as you won’t have to worry about rising rates increasing your payment over time.
- Fixed term. These loans are structured with a set repayment period, so you’ll know exactly how long it will take to pay off the loan. This can help you plan your finances more effectively and stay on track with your repayment goals.
- Lower closing costs. Compared to cash-out refinancing, home equity loans generally come with lower upfront costs. Since you’re not replacing your entire mortgage, the closing process is less complex and often less expensive.
- An additional monthly payment. Because a home equity loan is a second mortgage, it adds an additional monthly payment on top of your existing mortgage. This means you’ll need to manage two separate payments each month. Before taking out a home equity loan you’ll want to be confident that you can easily make both mortgage payments.
- Lower borrowing limits. With a home equity loan, you’re layering a new mortgage on top of your existing one, and both are secured by your home. Because of this, when lenders are determining how much you can borrow with a home equity loan, they have to take the balance of your current mortgage into account. Most lenders will let you borrow up 80% or 85% of your home’s value, minus your current mortgage balance.
Cash-Out Refinancing
With a cash-out refinance, you replace your existing mortgage with a new one that has a higher balance, and you take the balance difference as cash. For example, if your current mortgage balance is $200,000 and you refinance into a new $250,000 mortgage, you’ll receive $50,000 (minus closing costs) in cash.Benefits of Cash-Out Refinancing:
- Single monthly payment. One of the most appealing aspects of a cash-out refinance, is that it allows you to have only one mortgage payment. Instead of juggling two separate loans—as you would with a home equity loan—you’re simply replacing your existing mortgage with a new one. This can simplify your finances and reduce the risk of missing a payment. It’s especially helpful for those who are already managing multiple financial obligations such as personal loans, student debt or credit cards.
- Potential for a lower interest rate. If mortgage rates have dropped since you originally purchased your home, a cash-out refinance could allow you to lock in a lower rate on your entire mortgage balance. This not only reduces your monthly payment but can also save you thousands of dollars in interest over the life of the loan.
- Access to more cash. Because a cash-out refinance consolidates everything into one new loan, lenders typically see it as less risky than layering on a home equity loan. For this reason, lenders will often let you borrow more with a cash-out refinancing – usually between 80% to 90% of your home’s value. Being able to tap into a larger portion of your home’s equity can be especially useful if you’re funding a major renovation, consolidating significant debt, or covering large expenses like college tuition or medical bills.
- Higher closing costs. Refinancing your entire mortgage typically involves higher closing costs than taking out a home equity loan. These costs can include appraisal fees, title insurance, origination fees, and other lender charges. While some of these fees can be rolled into the loan, they still add to your overall cost. It’s important to factor these expenses into your decision and ensure that the benefits of refinancing outweigh the upfront costs.
- Extended loan term. When you refinance, you’re essentially starting over with a new mortgage term. If you’ve already paid down a significant portion of your original mortgage, refinancing could extend the time it takes to fully own your home. This might mean paying more interest in the long run, even if your monthly payments are lower. Homeowners nearing retirement or those focused on becoming debt-free sooner may find this aspect less appealing.
When weighing the pros and cons of a home equity loan and a cash-out refinance, keep the following things in mind:
- Interest rates: If you can secure a significantly lower rate by refinancing, a cash-out refinance might be the smarter move.
- Monthly payments: Can your budget handle two payments (with a home equity loan), or would you prefer the one monthly payment you’d get with a refinance?
- Loan amount needed: If you need a larger amount of money, refinancing may offer more borrowing power.
- Current mortgage balance: If your home is close to being paid off, a home equity loan might make more sense.