Is a Cash Out Refinance the Same as a Home Equity Loan?

Leveraging the equity built in a home can provide access to significant financial resources. Homeowners often consider various options to tap into this accumulated value, whether for large purchases, debt consolidation, or property improvements. Understanding the different financial products available for this purpose is an important step in making informed decisions about personal finances.

Cash-Out Refinance Explained

A cash-out refinance involves replacing an existing mortgage with a new, larger mortgage. The difference between the new loan amount and the balance of the old mortgage is then disbursed to the homeowner as a lump sum.

The interest rate for a cash-out refinance is determined by current market conditions, the borrower’s credit profile, and the loan-to-value (LTV) ratio. Lenders typically allow homeowners to borrow up to a certain percentage of their home’s appraised value, often around 80% for a cash-out refinance. Homeowners commonly use these funds for significant expenses such as extensive home renovations or consolidating higher-interest debts like credit card balances.

Home Equity Loans Explained

A home equity loan is a separate, second mortgage taken out against the equity in a home. Unlike a cash-out refinance, it does not replace the existing primary mortgage. Instead, it adds another loan to the property, creating two distinct mortgage payments. The amount of the loan is based on the available equity, which is the difference between the home’s current market value and the outstanding balance of the first mortgage.

Funds from a home equity loan are typically disbursed as a single lump sum, and the loan usually comes with a fixed interest rate. It is important to distinguish a home equity loan (HELOAN) from a home equity line of credit (HELOC); a HELOAN provides a one-time payout, whereas a HELOC offers a revolving credit line that can be drawn upon as needed. Lenders often allow combined loan-to-value (CLTV) ratios of up to 85% or 90% when considering a home equity loan.

Comparing Cash-Out Refinance and Home Equity Loans

The primary distinction between these two options lies in their impact on the existing mortgage. A cash-out refinance replaces the original mortgage entirely, resulting in a single new loan with updated terms and interest rates. Conversely, a home equity loan functions as a second mortgage, leaving the first mortgage intact and adding an additional payment obligation. This means a homeowner choosing a home equity loan will manage two separate loan payments each month.

Interest rates for cash-out refinances are generally tied to prevailing first mortgage rates, which can be either fixed or adjustable. Home equity loans, however, are typically offered with fixed interest rates. Closing costs also differ; cash-out refinances usually involve higher fees, often 2% to 5% of the loan amount, similar to a traditional mortgage refinance. Home equity loans often have lower closing costs.

Repayment terms vary as well, with cash-out refinances often spanning 15, 20, or 30 years, aligning with standard mortgage durations. Home equity loans typically have shorter repayment periods, commonly ranging from 5 to 20 years. The interest paid on both types of loans may be tax-deductible if the funds are used to buy, build, or substantially improve the home securing the loan, subject to federal tax law limitations.

Deciding Which Option Suits Your Needs

Choosing between a cash-out refinance and a home equity loan depends on individual financial circumstances and goals. If the primary objective is to lower the interest rate on the existing mortgage while also accessing equity, a cash-out refinance may be more suitable. This allows homeowners to potentially secure a lower rate on their entire mortgage balance, leading to significant savings if current market rates are lower than the original mortgage rate.

Home equity loans can be a better choice for homeowners who wish to keep their existing first mortgage, particularly if it has a very low interest rate. It is also often preferred for accessing smaller amounts of cash, as the closing costs can be less burdensome than a full refinance. A homeowner’s credit score and the loan-to-value (LTV) ratio of their property are important factors, as lenders assess these to determine eligibility and interest rates for both options.