You need money and you have it in the equity of your home. How do you get the equity out? Should you use a home equity line of credit as most people do? Did you know this is not the only option? There are other options available to you including the cash-out refinance and home equity loan. These loans are lump-sum loans, which means you receive the funds all at once and are unable to draw on them repeatedly as you could with a line of credit. They do offer many other benefits, though, which a HELOC does not. The final decision usually comes down to either a cash-out loan or a Home equity loan for most borrowers.
What is a Cash-Out Refinance?
A cash-out refinance is your first loan refinanced. It takes the current outstanding principal balance on your first mortgage and adds to it the amount of money you want to take out of the equity of your home. Most programs max out the amount of equity at a combined loan-to-value ratio of 80%; however, some lenders may allow a higher CLTV.
The cash-out loan is a first lien on your property. It combines the entire amount in one loan. This means you make one payment every month and have one loan to pay off if you were to move or refinance again. You can secure this loan with a variety of terms including 10, 15, 20 and 30-year terms. They are usually a fixed rate term as well, but some lenders allow adjustable rate loans. Because it is a first lien, you can usually secure a competitive interest rate on this loan type; however, your individual circumstances play a role. If you plan to roll the closing costs into the loan or you have a lower credit score, your interest rate may be slightly higher.
What is a Home Equity Loan?
A home equity loan is a second mortgage. It is similar to the cash-out refinance because you receive the cash in one lump sum; there is not a line to draw on repeatedly. This is where the similarities end, though. Because this loan is a second lien, it usually has higher interest rates to make up for the level of risk a second lien provides.
Other differences which occur with a home equity loan are the terms and interest rates. The terms usually top out at 15 years. You can find loan terms between 5 and 15 years with most banks. Because it is a second lien, they want their money paid back as quickly as possible in order to avoid the risk of default. Like the cash-out refinance, however, the interest rate is often fixed, but most banks charge higher interest rates than they do on the cash-out loan. A benefit of the home equity loan, however, is the lower closing costs they typically charge compared to a first lien mortgage.
Deciding Between a Cash-Out Refi and a Home Equity Loan
The decision between a cash-out refinance and home equity loan really depends on how long you plan to stay in the home and why you need the money. If you need the money only for a short amount of time to pay off a large debt which you cannot afford right now, such as medical debt, a home equity loan makes the most sense. In this case, you need a lump sum of money right now to pay your medical bills but you have the money to pay the debt off within 5 years or so. If you take out the short-term home equity loan you will pay less interest over the life of the loan. This is the most affordable option. If you were to roll the debt into your first mortgage and take a 30-year term, the one medical bill you have could really get expensive over the term of the loan.
If, on the other hand, you need to borrow money to remodel your kitchen or put an addition on your home, you need a larger sum of money. If you know you cannot pay the large sum back in 5 to 10 years, rolling it into your first mortgage might provide you with the best option. With a first mortgage, you can secure a lower interest rate and have longer to pay the debt off. This can be the more affordable option for you since you have a large debt to pay back.
Another determining factor is how long you held your first mortgage already. Have you knocked off 10 years or more off of the term of the loan already? If so, do you really want to reset your first mortgage back at 30 years? If you cannot afford a shorter term, you might consider a home equity loan just so you continue to pay down the first mortgage in the manner you started paying it. The length of the home equity loan and the interest rate will help you determine which decision is right for you. You should look at both options side-by-side to determine the right choice. In some cases, even resetting the first loan period back to its original is the more affordable option.
Deciding between a cash-out refinance and home equity loan is a personal decision. You have to factor in the interest rate, closing costs and the new term to see which option is the most affordable. Sometimes rolling it all into one loan and starting over from scratch makes the most sense, while other times, taking out a short-term home equity loan saves you the most money in the long run. Talk to your lender about your various options to help you determine the right choice for you.