Owning a home is an expensive venture. But your home could be earning you money through equity and it might be time to convert that equity into cash. You could lower your interest rate, convert equity to cash or both through options like a home equity loan or cash-out refinancing. While both give you the opportunity to cash in on your home’s value, each one operates differently. Here’s the difference between a home equity loan and cash-out refinancing so you know which one may be right for you. Have questions about related matters? A financial advisor can help you gain valuable insight into possible answers to those questions.
What Is a Home Equity Loan?
A home equity loan is a lump-sum loan, usually with a fixed rate, that serves as a second mortgage. Your home serves as collateral to secure the loan based on how much equity you have in your home. The longer you’ve owned your home, the more equity you have available to you.
Your credit score matters less to lenders since your home is used as collateral, otherwise known as a secured loan. While you continue to pay off your first home loan, you’ll be responsible for the second mortgage, or your home equity loan. So you’ll need to pay off two mortgages at once. Lenders will usually pay your closing costs when you take out a second mortgage.
What Is Cash-Out Refinancing?
Cash-out refinancing is when you take out a new loan to replace your mortgage and use the equity you’ve built up to “cash out.” Your new loan could be for longer repayment terms, a lower interest rate or both. Since you’ll get a new loan, you can pocket the money you receive from refinancing.
Cash-out refi’s usually come with fixed interest rates, although some lenders offer adjustable rates. Interest rates are generally lower compared to home equity loans. However, you’re on the hook for closing costs with this option.
Which One Is Right for You?
Before you make your decision on which one is right for you, ask yourself a few questions.
Can I lower my interest rate? Lower interest rates, in general, can be a good time to refinance your home. But instead of paying for two loans at once, avoid a home equity loan and opt for a cash-out refinance. That way you aren’t paying for a home you bought when rates were higher.
Which one do I qualify for? A home equity loan is a type of second loan, which means it takes second priority to the first one. They’re usually harder to qualify for than cash-out refinancing. A cash-out is like a brand-new loan, which means it takes first priority.
How long will it take to repay? Home equity loans are usually shorter, with terms around 15 years. Cash-out refinancing terms usually range from 15 or 30 years, like a regular mortgage. Keep in mind, though, that the longer the term, the more you’ll pay in interest over the life of the loan.
What can I expect to pay in interest? Both home equity loans and cash-out refi’s offer competitive interest rates. But if you shop around and can’t find interest rates lower than what you pay now, it might not be worth it to try either.
Am I going to get taxed on proceeds? Unless you’re selling your home, you shouldn’t expect to pay capital gains tax from either a home equity loan or cash-out refinancing. In both instances, they’re loans, or money you’re borrowing with the intention of paying back. So they’re not taxable.
Can I afford two loans? If you can make payments on both your first mortgage and your home equity loan, having two payments shouldn’t be an issue. But if you think you’d struggle to make payments, a cash-out refi would work better for you since it gives you one monthly mortgage payment.
The Bottom Line
The main difference between a home equity loan and a cash-out refinance is that a cash-out refinance loan converts one mortgage into a separate larger one. In most cases, the more cash you need the more a cash-out refinance makes sense. Home equity loans create a second mortgage and usually have lower closing costs than a cash-out refinance but also carry higher interest rates.
Tips on Personal Finance
- Consider talking to a financial advisor about whether converting your home’s equity into cash is wise and, if so, what would be a smart way to do that. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Before you choose between a home equity loan and a cash-out refi, make sure you review your current home situation. How much equity do you have in the home? If you’ve recently bought your home, you might not qualify for either since you haven’t made payments long enough to gain equity. However, if you’ve owned your home for a few years, you could expect to hold a sizable amount of equity and possibly cash out on it.
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