Which Is Better, a Refinance or a Home Equity Loan?

Whether you need money due to a job loss or for a planned expense, tapping into your home equity is one option for homeowners. However, it comes with a few added costs and risks, such as foreclosure if you can’t repay the loan.

A home equity loan and cash-out refinance are two options to get access to home equity. However, each of these has pros and cons and works differently.

So which is better, a refinance or a home equity loan? In this guide, we’ll explore the differences between the two options to help you determine which one is better for your financial needs.

Understanding Home Equity Loans and Cash-Out Refinances

The best way to determine which is better, a refinance or a home equity loan, is to understand how these loans work.

What Is a Home Equity Loan?

A home equity loan is usually a fixed-rate loan that allows you to borrow against the equity of your home and get a lump sum of cash. It’s also known as a second mortgage because you’ll make a monthly mortgage payment, along with a payment for your home equity loan.

Usually, your current mortgage and home equity loan add up to 85% of the property’s appraised value. However, the exact amount can vary. Here’s an example to help you understand how this works.

If you have a home valued at $500,000 and have $250,000 left on your mortgage loan, you may take out a home equity loan of $175,000. This means you’re borrowing 85% of the total value of your home.

What Is a Cash-Out Refinance?

A cash-out refinance involves taking out a new, larger mortgage to replace your existing loan. You’ll get cash for the difference between the two loans. Typically, cash-out refinance has a limit of 80% of the property’s value. However, this can vary depending on the lender.

Like a traditional mortgage, cash-out refinances can be fixed or variable. Here’s an example to help you understand how this type of loan works.

If you have a home valued at $500,000 and have a $250,000 loan balance left on your mortgage, you can take a cash-out refinance loan of $400,000. You’ll use $250,000 to pay off your primary mortgage balance and will get $150,000 in cash.

Pros and Cons of Home Equity Loans

If you’re considering borrowing a home equity loan, consider these pros and cons to make an informed decision.

Pros 

• Fixed interest rates and predictable monthly payments
• You can get access to your home’s equity without having to sell it
• You can get cash for larger expenses like home renovations
• Interest may be tax-deductible if you use the money to improve your home

Cons 

• You risk foreclosure if you default on the loan
• You’ll have two loan payments instead of just a mortgage
• Limited and more expensive options for home equity loans for bad credit

Pros and Cons of Refinance

Like home equity loans, cash-out refi also has pros and cons that you should be aware of.

Pros

• You may be able to get a lower interest rate than what you’re currently paying
• You’ll have a single payment instead of two
• You can use the cash for any purpose
• Interest on the loan may be tax-deductible

Cons

• Loan eligibility and underwriting can be quite stringent
• Loan approval and funding can take long
• Upfront closing costs can be high
• You may have to pay your mortgage longer if you choose a longer repayment term

Key Differences Between Cash-Out Refinance and Home Equity Loans

Cash-out refinances and home equity loans have several differences in repayment terms, interest rates, and more.

Interest Rates

Cash-out refinances can be fixed or variable, while home equity loans usually come with fixed interest rates, so your monthly payments will remain the same throughout the life of the loan.

Cash-out refinance interest rates are usually lower compared to home equity loans. However, since you’ll be replacing your original mortgage with a new one, it's important to avoid this option if you’re getting higher interest rates than what you’re currently paying.  

Repayment Terms

With a cash-out refinance, you’ll have a single payment each month and a longer repayment period. A longer repayment term can make your monthly payments more manageable, but you’ll also pay more in interest over the life of the term.

In contrast, home equity loans usually have term lengths of 5-15 years, and while you’ll have two separate payments each month, you’ll also repay the loans sooner and may pay less in interest overall.

Monthly Payments

When you borrow a home equity loan, you’re getting a second mortgage. This means that you’ll make two payments each month: the home equity loan payment and the mortgage payment. You’ll make payments to cover the principal and interest for both loans.

A cash-out refinance replaces your existing mortgage, so you’ll only have a single monthly payment. This reduces the number of loans you have, and you’ll have a single, larger loan.

What Are the Requirements for Home Equity Loans and Refinancing?

Qualifying for a cash-out refinance is usually more difficult than a home equity loan. However, eligibility requirements may vary depending on the lender. Usually, you’ll need to meet these requirements to qualify for cash-out refinance:

• Over 20% equity in the property
• Loan-to-value (LTV) of 80% or less
• Debt-to-income (DTI) ratio of 43% or less
• A FICO score of 620 or more
• Employment and income verification
• Property appraisal to verify your home’s current value

A home equity loan is usually easier to qualify for. Here’s what you’ll need:

• A credit score of at least 600
• Employment and income verification
• Over 20% equity in the property

How To Choose Between Home Equity Loans and Refinancing?

To determine which is better, a refinance or home equity loan, you’ll need to consider your financial needs, the purpose of the loan, and your monthly budget. Here’s who each option is right for.

• Cash-Out Refinance: This is usually a better option for those who want a single, more affordable payment each month. It’s also usually a good option for those who qualify for a better rate on a new mortgage or when you want to change the loan terms.
• Home Equity Loan: If you already have a low interest rate on your existing mortgage, getting a home equity loan may be a better idea. This is also a good option for homeowners who have already built substantial equity in their home.

A home equity sharing agreement can be an alternative to both refinancing and home equity loans. It can be beneficial if you want to access your home’s equity without taking on additional debt. Instead of repaying a loan, you’ll share a portion of your home’s future value with the investor when you sell or refinance, providing flexibility in managing your finances.

How To Get a Home Equity Loan or a Cash-Out Refinance?

There are several similarities when it comes to the application process for a home equity loan and cash-out refinance. The biggest difference between both options is that with cash-out refinance, you’ll be replacing your existing mortgage with a new one.

Here’s how to apply for cash-out refinance:

1. Determine the loan amount you need to borrow.
2. Determine your home value and the amount of equity you have.
3. Calculate your LTV.
4. Shop around to compare the terms and rates of multiple lenders.
5. Check eligibility requirements to ensure you qualify.
6. Gather your documents and submit a formal application.
7. Get an appraiser for property valuation.
8. Go through the underwriting process and close the loan to get access to cash.  

When applying for a home equity loan, here’s the process you’ll usually need to follow:

1. Review your finances and budget to determine how much you can pay each month.
2. Research loan options and prequalify to see what terms and rates you qualify for.
3. Gather necessary documents, such as tax returns, W-2s, and bank statements.
4. Fill out the loan application and submit it for processing.
5. Schedule a home appraisal.
6. Go through the underwriting and closing process to get access to cash.

Should I Get a Home Equity Loan or Refinance?

Cash-out refinances and home equity loans both allow you to access the equity in your home for home improvements or other financial needs. Refinancing may be a better choice if you want to lower your mortgage rate and have a single loan to manage.

Home equity loans are usually better if you want to pay off your loan faster and keep your mortgage as is. Ultimately, the best choice will depend on your mortgage rate and your financial requirements. With both types of loans, it’s important to make timely payments, since defaulting can lead to foreclosure.