A home equity loan and a cash-out refinance are two ways to access the value that has accumulated in your home. Although the loans are similar, they’re not the same. If you already have a mortgage, a home equity loan will be a second payment to make, while a cash-out refinance replaces your current loan with a new term, interest rate and monthly payment.
Uses for home equity loans and cash-out refinances
Buying a home is often touted as a “forced savings account.” Making a monthly payment on the loan, along with any property appreciation, builds value in the home. But you can’t access that value, known as equity, without selling. Instead, you have to borrow the equity, which these loan products allow you to do.
Of course, you need to have a bit of home equity first.
“If you recently purchased your home, you may not have a lot to work with. If you’ve owned your home for five or 10 years and made your payments on time, then you will have more equity in your home,” says Johnna Camarillo, assistant vice president at Navy Federal Credit Union.
To figure out how much home equity you have, find out what your home’s value is and how much you still owe on the mortgage. If the difference between the two is a positive number, that’s the equity you have in the home. But if you owe more than your home is worth, you’re not a candidate for a cash-out refinance or a home equity loan.
How the loans are similar
- Both commonly come with fixed interest rates, though adjustable rates are possible with a cash-out refi
- You’ll typically need an after-transaction loan-to-value ratio of 90% or less to qualify for either one
- You’ll get a lump-sum payout on both products
How the loans are different
- Interest rates are generally lower for cash-out refinances than home equity loans
- Lenders will often pay all or most of the closing costs on home equity loans, Camarillo says. That’s not the case for most cash-out refis.
- A refi is one big loan, while a home equity loan is a loan in addition to your first mortgage
Frequently asked questions
Is it better to refinance or take out a home equity loan?
First, consider mortgage rates.
“If a customer can lower their interest rate on their entire first mortgage and then take some additional cash out,” consider a cash-out refi, Camarillo says.
If today’s rates are higher than your existing mortgage’s rate, a home equity loan likely makes more sense.
Which is easier to qualify for?
A cash-out refi will usually be a bit easier to qualify for. It is replacing your primary mortgage; lenders like that because it gives them “first position” as a creditor.
A cash-out refi will usually be a bit easier to qualify for.
Home equity loans are “second mortgages,” which means the loan is second in line when it comes to payback priority.
And both loans are worth shopping for, to get the best rate and terms. You don’t have to go to your current mortgage lender for either product.
How much can you borrow?
“In general, when loan options are secured by the home, the amount a person can borrow is determined by things such as the equity a person has in their home, their credit score and debt-to-income ratio,” says PK Parekh, vice president of Discover home equity loans.
Expect your all-in loan debt to be somewhere around 90% of your home’s value or less.
When do I have to pay it back?
Cash-out refis can extend to 15 or 30 years — and even longer — just like a primary mortgage. Home equity loans are generally shorter, often up to 15 years.
“Try to go for the shortest term possible but still have a payment you can afford,” Camarillo says. “Depending on how much you’re borrowing, the difference between a 10- and a 15-year equity loan may only be $50 a month. But the amount of interest you’re going to pay over that extra five years is a lot of money.”
Are the proceeds taxable?
The equity in your home is a profit — in tax jargon, it’s called a capital gain — that you realize only when you sell your house. So the money you get from either a cash-out refinance or a home equity loan is not taxable because it’s borrowed money you have to pay back.
Is the interest paid tax deductible?
Even with recent changes to tax laws, there are instances when you can still deduct the interest you pay on home equity loans and cash-out refinances. For home equity loans established in 2018, the proceeds must be used to “buy, build or substantially improve the taxpayer’s home that secures the loan,” the IRS says.
A cash-out refinance is treated like all first-lien mortgages. In 2018, the interest deduction is limited to all loans secured by a qualified residence totaling $750,000 or less — or $375,000 for a married taxpayer filing separately.
To dig into the details on either scenario, talk to a trusted tax advisor.