Roger Odoardi
As mortgage experts, we field questions from clients about refinancing every day. Some are curious about which refinancing options are available to them; others are interested in learning when is the best time to refinance; still others wonder whether refinancing makes sense for their specific situation. Recently, we’ve received quite a few calls from borrowers inquiring about home equity loans, when it was clear that what they really needed was cash-out refinancing, and vice versa.
Home equity loans and cash-out refinancing serve the same basic purpose — they enable you to secure funding for major expenses, such as home improvement projects, medical bills, college tuition, high-interest debt and more. However, they come with unique advantages and disadvantages, and are best suited for different scenarios. In this blog post, we’ll take a closer look at the difference between cash-out refinance and a home equity loan.
Home Equity Loans & Home Equity Line of Credit
What is a home equity loan and line of credit?
A home equity loan or home equity line of credit (HELOC) are mortgages that enable you to borrow against the value of your home, minus your remaining mortgage, by using your home as collateral. If you’re approved for a home equity mortgage, the lender will determine how much money you can borrow based on your home’s value and any debts against you. The bank will present that amount to you in a lump sum, which you must then repay at a fixed rate over a set number of years if you have a home equity loan or at an adjustable rate and set term if you have a home equity line of credit. If you default on your home equity mortgage, the lender reserves the right to take possession of your home.
Requirements to qualify for a home equity mortgage vary from lender to lender, but typically include the following:
- A credit score of 620 or higher
- More than 20 percent equity/a loan-to-value ratio (LTV) of 80 percent or below, as determined by an appraiser
- A low debt-to-income (DTI) ratio (ideally less than 43 percent, though some lenders may permit a higher DTI)
- Stable credit and bill repayment history
- Income and asset verification documentation
What are the advantages of a home equity mortgage?
Compared to unsecured loans, such as credit cards and personal loans, home equity mortgages typically have lower interest rates, which helps keep borrowing costs low. Home equity loan interest rates are also fixed over the life of the loan, which makes it easier to budget for monthly payments. If you have sufficient equity, it’s easier to qualify for a larger sum of money with a home equity loan than other similar mortgage types.
A HELOC typically comes with an initial draw period of five to ten years during which you can use the available credit, much like a credit card. During this draw period the monthly payment is usually interest-only, which allows for a more affordable monthly payment. Since mortgage interest rates are tax deductible (as compared to, say, credit card interest), a home equity loan or HELOC could lower your taxable income and help you secure a larger tax refund.
And the disadvantages?
As mentioned above, a home equity mortgage uses your home as collateral, which means if you fail to make payments on your loan, you could lose your home to foreclosure. Home equity mortgages tend to come with fees attached; depending on the lender, you could pay a number of fees, such as application fees, appraisal fees, underwriting fees, document preparation fees, closing costs and more. Should you decide to one day sell your home, borrowing against your home’s equity decreases your potential return on investment, which could negatively affect your ability to afford a down payment on your next property. As far as a HELOC is concerned, although an interest-only payment is generally more affordable, only paying down the interest means you aren’t paying down your principle. The interest rate on a HELOC in typically an adjustable rate which is not advantageous in a rising rate market
Cash-Out Refinancing
What is cash-out refinancing?
Cash-out refinancing is when you leverage your home’s equity to borrow more money than is owed on your existing mortgage and receive the difference in cash, which you can then use to secure funding for major expenses, such as home improvement projects, medical bills, college tuition, high-interest debt and more. There are three main cash-out refinancing loan programs:
- Conventional cash-out – available to homeowners with more than 20 percent equity
- VA cash-out – available for U.S. veterans and active service members, VA cash-out refinancing typically enables the borrower to access a larger amount of equity from their loan
- FHA cash-out – available to homeowners with more than 15 percent equity
Since a cash-out refinance is a new mortgage, all the standard application requirements apply. To qualify, homeowners should meet the following standard criteria:
- Have owned the home for at least six months to one year (depending on the loan program)
- A credit score of 620 or higher (though the exact minimum varies from lender to lender)
- More than 20 percent equity/an LTV of 80 percent or below, as determined by an appraiser
- A low DTI (again, ideally less than 43 percent, though some lenders may permit a higher DTI)
- Stable credit and bill repayment historyIncome and asset verification documentation
What are the advantages of cash-out refinancing?
If you purchased your home when mortgage rates were high, a cash-out refinance could give you a lower interest rate. As mentioned above, you can use cash-out refinancing to pay off major expenses, such as high-interest debt; by consolidating your debt, you could save thousands of dollars in interest and improve your credit score. Like home equity loans, the interest you pay on a cash-out refinance mortgage is tax-deductible, which means you could secure a larger tax refund.
And the disadvantages?
If you’re considering applying for a cash-out refinance, keep in mind that it will likely change the terms of your mortgage, either by increasing the amount you owe or possibly extending your repayment period. If you owe more on your loan than the value of your home, you could find yourself in a difficult financial position if property values fall.
If you intend to use your cash-out refinance to consolidate debt, take care to develop a sustainable spending plan prior to making any payments. Many borrowers fall into a pattern of reloading — that is, taking out a loan to pay off existing debt and “reloading” your credit cards, only to rack up new debts — which, if you aren’t careful, could result in bankruptcy. Like a home equity loan, there are fees associated with cash-out refinancing, specifically closing costs, so it’s important to budget accordingly.
Home Equity vs. Cash-Out Refinance
What are the primary differences between a cash-out refinance and a home equity mortgage?
The most significant difference between a cash-out refinance and a home equity mortgage is that cash-out refinancing replaces your existing mortgage, whereas a home equity is a second mortgage in addition to your existing mortgage. This is an incredibly important distinction because it means you only have to manage one loan payment, which is typically easier to keep track of and budget for. Another key difference is that cash-out refinancing typically offers lower interest rates than a home equity mortgage. Although the upfront cost of a cash-out refinance is higher than the additional monthly expense of a home equity loan in the short-term, cash-out refinancing is less expensive in the long-term.
When should I choose a home equity mortgage over a cash-out refinance, and vice versa?
There’s a relatively easy way to determine whether a home equity mortgage or a cash-out refinance is the better option for your unique situation. Ask yourself the following:
- How do I intend to use this money?
- Cash-out refinancing is better suited for planned expenses, such as home renovations or paying for college tuition. If you want to create a safety net for unexpected financial burdens (say, for example, your roof springs a leak and you determine it’s in need of replacement), a home equity mortgage is your best option.
- Will I be able to pay off the loan in the coming six months?
- Although a cash-out refinance has a higher upfront cost than a home equity mortgage, cash-out refinancing comes with lower out-of-pocket monthly payment expenses, making it the more affordable option for long-term repayment plans. If you believe that you’ll realistically be able to pay off your loan in the span of six months, consider a home equity mortgage to save on upfront costs.
Before deciding to apply for a home equity mortgage vs. a cash-out refinance, talk to a mortgage specialist to evaluate your specific needs and get a better understanding of the options available to you. With decades of collective mortgage industry experience, Blue Water Mortgage Corporation’s brokers have the expertise to help you make an informed decision about your home equity loan or cash-out refinance. Contact us today to set up a free discovery call and get started.
Roger Odoardi
Roger is an owner and licensed Loan Officer at Blue Water Mortgage. He graduated from the University of New Hampshire’s Whittemore School of Business and has been a leader in the mortgage industry for over 20 years. Roger has personally originated over 2500 residential loans and is considered to be in the top 1% of NH Loan Officers by leading national lender United Wholesale Mortgage.
