Cash-Out Refinance vs. Home Equity Loan: Which Is Better?

Homeowners often leverage their property’s equity for various financial objectives. Whether funding a significant project, consolidating debts, or adjusting mortgage terms, understanding available options is crucial. Cash-out refinancing and home equity loans are two common avenues for tapping into home equity, each offering distinct advantages depending on an individual’s financial situation and goals.

Understanding Refinancing and Home Equity Options

A mortgage refinance replaces your existing home loan with a new one. For example, a homeowner might refinance to secure a lower interest rate, change the loan term, or convert an adjustable-rate mortgage into a fixed-rate mortgage. When a refinance includes taking out additional funds beyond the outstanding mortgage balance, it is known as a cash-out refinance. These funds are received as a lump sum at closing.

A home equity loan functions as a second mortgage on your property. This loan provides a lump sum, repaid over a fixed period with a fixed interest rate. The loan amount is determined by your home’s available equity. Repayment begins immediately with regular monthly installments of principal and interest.

Another option for accessing home equity is a home equity line of credit (HELOC). Similar to a home equity loan, a HELOC is a second mortgage. However, it operates as a revolving line of credit, much like a credit card, allowing you to borrow up to a certain limit as needed. Borrowers can draw funds up to a predetermined credit limit during a “draw period,” often lasting around 10 years, where payments may be interest-only. After the draw period, a “repayment period” begins where both principal and interest are paid on the outstanding balance.

Key Distinctions Between Refinancing and Home Equity Loans

A cash-out refinance replaces your current primary mortgage with an entirely new one, resulting in a single loan and one monthly payment. Conversely, a home equity loan or HELOC is a separate, secondary loan that exists alongside your original primary mortgage. This means you will have two distinct mortgage payments each month: one for your primary loan and another for the home equity product.

A cash-out refinance provides a single, large lump sum at closing, suitable for major, one-time expenses. A home equity loan also delivers a lump sum. In contrast, a HELOC offers flexibility, allowing you to draw funds as needed over time, which is advantageous for ongoing or uncertain expenses.

Cash-out refinances typically offer fixed interest rates, providing predictable monthly payments. Home equity loans also generally come with fixed interest rates. HELOCs, however, are predominantly associated with variable interest rates, meaning monthly payments can fluctuate based on market changes. Some HELOCs offer the option to convert a portion of the balance to a fixed rate.

Closing costs differ significantly among these options. A cash-out refinance generally involves costs similar to a new mortgage. Home equity loans and HELOCs usually have lower closing costs. More details on closing costs are discussed later.

Interest paid on both cash-out refinances and home equity products can be tax-deductible. Per IRS Publication 936, interest on home equity debt is deductible if funds are used to buy, build, or substantially improve the home securing the loan. This deduction is generally limited to interest on the first $750,000 of qualified home indebtedness ($375,000 for married individuals filing separately) for loans originated after December 15, 2017.

Aligning Your Financial Goals with the Right Option

If your goal is to secure a lower interest rate on your entire mortgage balance or reduce your overall monthly mortgage payment, a cash-out refinance is often the most suitable solution. This approach allows for a complete restructuring of your primary mortgage, potentially extending or shortening its term.

If you require a substantial lump sum for a specific, well-defined expense, a home equity loan or a cash-out refinance can be effective choices. Both provide the full amount upfront. A home equity loan allows you to keep your existing primary mortgage intact, while a cash-out refinance rolls the new funds into a single, larger mortgage.

For those needing flexible access to funds over an extended period, such as for ongoing home improvements, educational expenses, or managing fluctuating personal needs, a Home Equity Line of Credit (HELOC) is more appropriate. A HELOC permits you to draw funds as needed, up to an approved limit, and you only pay interest on the amount actually borrowed.

When consolidating high-interest debt, both cash-out refinances and home equity products can offer lower interest payments. A cash-out refinance allows you to roll the debt into a new, lower-interest mortgage payment. Alternatively, a home equity loan provides a lump sum to pay off these debts, while a HELOC offers a revolving line of credit to manage various unsecured debts over time. The choice often depends on your current mortgage rate and the total amount of debt to be consolidated.

If your objective is to shorten or lengthen the term of your existing mortgage, a traditional rate-and-term refinance is the direct path. While a cash-out refinance can also adjust the term, its primary function is to extract equity.

Important Considerations for Your Decision

Before committing to either a cash-out refinance or a home equity product, assess your available home equity. Lenders typically require you to maintain a certain percentage of equity in your home, often seeking to keep your combined loan-to-value (CLTV) ratio at or below 80% to 90% after the new loan.

Your credit score and financial health play a role in determining eligibility and interest rates for home-secured loans. For cash-out refinances, a credit score of 620 or higher is typically required for conventional loans. For home equity loans and HELOCs, credit scores in the mid-600s to high-600s are generally sought. A lower debt-to-income (DTI) ratio, which compares monthly debt payments to gross monthly income, is also favorable. Lenders typically prefer a DTI ratio below 43% to 50%.

The prevailing interest rate environment influences your decision. If current mortgage rates are significantly lower than your existing mortgage rate, a cash-out refinance becomes more appealing. Conversely, if rates are high, a home equity loan or HELOC might be preferable to avoid refinancing your entire primary mortgage at an unfavorable rate.

Understanding all associated closing costs and fees is important to assess the true cost of borrowing. These fees can include loan origination, appraisal, title insurance, and attorney fees. Compare the total costs for each option and consider how long it will take to recoup these expenses. Some lenders may offer “no-closing-cost” options, but these often come with a higher interest rate.

Consider the long-term impact on your monthly budget and financial plan. Taking on additional debt will increase your monthly financial obligations. Evaluate whether your income can comfortably support these new payments and how they align with your long-term savings, investment, and retirement goals.