If you need cash and you know you have home equity available, you might wonder what the best way is to get the cash. Should you take a cash-out refinance? Is it better to take a home equity loan and leave your first mortgage alone?
Both options have pros and cons. Understanding which option is right for you depends on your situation. Below we help you understand the positives and negatives of both options to help you determine what is right for you.
The Cash-out Refinance
A cash-out refinance requires you to refinance your first mortgage for a larger amount than you currently owe. Most loan programs allow you to take out up to 80% of your home’s value, with the exception of the VA loan, that allows you to take out up to 100% of your home’s value.
Here’s how that would work:
If your home is worth $300,000, a cash-out refinance lender will let you borrow as much as $240,000. Now let’s say your outstanding balance on your current mortgage is $200,000. That leaves you with $40,000 to do with as you wish, if you were to take out all of your home equity up to the 80% allowed amount.
The Benefits of a Cash-Out Refinance
Taking cash-out of your home’s equity using your first mortgage does have its benefits. They include:
- You can use the cash for any reason you see fit. Unless you have an exceptionally high debt ratio, lenders typically don’t tell you what to do with the funds.
- You receive the funds in one lump sum. You can then do with them as you see fit, whether you owe other creditors money, you put it in a bank account, or you fix up your home with it.
- The interest rate is usually fixed. You can still grab a low interest rate, but you don’t have to worry about it fluctuating throughout the life of the loan.
The Disadvantages of a Cash-Out Refinance
Unfortunately, there are downsides to using the cash-out refinance. They include:
- You’ll usually pay high closing costs. Because you are refinancing your first mortgage, the lender and title company have a lot of work to do on your loan. This translates into high closing costs, similar to what you paid on your purchase loan.
- You may stretch out your loan’s term. If you already paid several years on a 30-year term, but then you take out another 30-year term, you just added years to your mortgage term. This means you’ll pay more interest and it will take longer to own your home free and clear.
- You may pay a higher interest rate. Because you are increasing your loan amount, you become a higher risk for lenders. This usually means that they will charge you a higher interest rate in order to make up for that risk.
The Home Equity Loan
You also have the option to leave your first mortgage alone and tap into your home’s equity with a home equity loan. This loan helps you tap into your home’s equity. Using the above example, the loan would be worth $40,000. The $200,000 first mortgage is left as-is. You don’t change lenders, interest rates, or terms on that loan. But you will now have two mortgage payments to make and keep track of throughout the loan’s term.
The Benefits of a Home Equity Loan
There are some definite benefits to the home equity loan versus the cash-out refinance. They include:
- Just like a cash-out refinance, you get a lump sum payment to do with as you see fit. Whether you pay off your debts, fix up your home, or put it away for a rainy day, the money is yours to use.
- You can usually get a fixed interest rate. Unlike HELOCs, the home equity loan offers a fixed interest rate. This means a predictable monthly payment and no risk of payment shock when your payment increases and you are unable to afford it.
- The closing costs are often lower on a home equity loan than the cash-out refinance. Lenders don’t have to do as much work on a second property lien, which means fewer closing costs for you.
The Disadvantages of a Home Equity Loan
There are a few downsides you should be aware of when looking at the home equity loan:
- You owe interest on the full amount of the loan. This is unlike a home equity line of credit where you only pay interest on the money you ‘withdraw.’ All other funds remain with the mortgage company unless you need them. This way you don’t owe interest on money you didn’t use.
- Your home is just as much at risk of foreclosure as it is with a first mortgage. If you miss payments, the lender can start the foreclosure process. If you used the loan to consolidate unsecured debt, you just made that debt secured with a home equity loan.
- You can get upside down on your loan must faster when you take out your equity with a home equity loan. If home values drop, you have little to no equity in your home.
If you need money from your home, get quotes for different types of loans, including the cash-out refinance and home equity loan. Pay close attention to the closing fees, interest rates, and the terms of the loan before you decide which option is right for you.