Cash-out refinancing and home equity loans are both ways for borrowers to access the equity they've accumulated in their homes and use it for home improvement projects, debt consolidation, or other financial needs. Since they're secured by the borrower's house, they're generally easier to access than other types of loans.
What Is Cash-Out Refinancing?
Cash-out refinancing replaces a homeowner's existing mortgage with a new home loan for more than they owe on their house. That difference is paid out in cash, and can be used for anything the borrower wishes. The interest rates for this type of refinancing are slightly higher than the original mortgage, due to its correspondingly higher loan amount. Generally speaking, cash-out refinance limits the amounts paid out to 80 to 90 percent of the equity accumulated in the house.
What Is a Home Equity Loan?
A home equity loan is a type of second mortgage that allows homeowners to borrow money by leveraging the equity they've built up in their houses, using it as collateral. There are two main types of home equity loans: either term loans or lines of credit.
Fixed rate or term loans are the traditional choice, in which lenders provide a single, lump-sum payment, which is repaid over a set period of time at an agreed-upon interest rate, which remains stable over the life of the loan.
A home equity line of credit, on the other hand, is a variable-rate loan that works in a very similar fashion as a credit card, and sometimes even comes with one. Borrowers are pre-approved for a certain spending limit, from which they can withdraw money via the aforementioned credit card or special checks. Monthly payments vary according to the amount of money borrowed and the prevailing interest rate. Just like its fixed-rate loan counterpart, lines of credit have a set term, which once reached, signals that the balance must be paid in full.
Pros and Cons of Cash-Out Refinancing
Cash-out refinancing can have very real benefits when compared with other types of loans. In the first place, it usually offers substantially lower interest rates than home equity lines of credit or home equity loans, especially if you purchased your home when mortgage rates were much higher. Many people use this type of refinance in order to pay off high-interest credit cards, which in turn can improve your credit score by reducing your credit utilization ratio. Additionally, unlike credit card interest, mortgage interest payments are tax-deductible. Therefore, a cash-out refinance could reduce your taxable income and lead to a bigger tax refund.
Despite the considerable advantages a cash-out refinance can offer, there are also significant drawbacks. In the first place, since you're putting your equity on the line as collateral, if you can't make payments, you may lose your home. The new terms you've negotiated with the new mortgage may also be less beneficial than the previous ones, so it's a good idea to double check all interest rates and fees before making a final decision. Lastly, the refinance will have a number of associated costs you must pay, including closing costs (typically three to six percent of the mortgage), and private mortgage insurance, if you borrow more than eighty percent of your home's value.
Pros and Cons of Home Equity Loans
Though perhaps not as low as for a cash-out refinance, home equity loans generally have lower interest rates than unsecured loans, and they are completely fixed, as opposed to lines of credit. They can also be somewhat easier to qualify for, even if you have bad credit. Interest costs may be tax-deductible, just as with a refinance, but not everybody qualifies for this perk. Assuming you have a good amount of equity in your home, this type of loan can allow you to access large amounts of it, to be used however you see fit.
One of the most salient disadvantages of a home equity loan is the same as with a cash-out refinance: any time you're using your home as collateral, there's an element of risk involved, and you may lose your home if you miss payments. Another less obvious issue is the possibility of property values declining in your area, which can work against you if you've tapped all the equity in your home. A common use for a home equity loan can be to carry out remodels on the property. However, these should be approached with an eye to adding value to the home. For instance, a pool may seem like a great idea, but remodeling a kitchen or bathroom will add substantially more value.
Lastly, home equity loans can feed into the vicious cycle of spending, borrowing, and spending, only to then sink deeper and deeper into debt. This unfortunate behavior pattern is so common that lenders have coined a term for it: reloading.
Qualifications for Cash-Out Refinancing
Lenders view cash-out refinance as risky, and therefore may have more stringent requirements:
- A credit score of 740 or higher (to get the lowest interest rate)
- A debt-to-income ratio below 45%
- A stable two-year work history
- A max loan-to-value limit of 80% (for a standard rate or term loan, you can borrow up to 95%)
They will require a good amount of equity already accumulated in the home, and they will scrutinize your total debt payments, including child support, installment loans, credit card bills, IRS payments and even student loans that are not yet being repaid.
Qualifications for Home Equity Loans
No two lenders will analyze applications and their requirements in exactly the same way, but most will evaluate the following:
- A credit score of 680 or higher (for the most favorable rate)
- A combined loan-to-ratio value of 70%-90%
- A debt-to-income ratio below 45%
- Stable credit history and good employment record (at least 2 years)
- Fees varies by lender, but generally reaches up to 8%
By familiarizing yourself with the basic requirements for both home equity loans and cash-out refinance loans, you can find the best option for your needs.