Cash Out Refinance vs Home Equity Loan
If you need money quickly and have considerable equity built up in your home, it’s possible to tap into that equity through either a cash out refinance or a home equity loan. Both options offer benefits and drawbacks. In today’s post, we’ll explore both options and compare the advantages and disadvantages to each.
Cash Out Refinance
Let’s start with the cash out refinance option. With a cash out refinance, homeowners can refinance their current mortgage for more than what they owe and receive the difference as cash. This money can be used however the homeowner wants, but most financial advisers would suggest using the money for things like paying off other high interest debt (credit cards, student loans, etc.), applying the money toward another investment such as the purchase of a rental home or small business startup, or to help pay for a child’s education. Other options might include paying for an aging parent’s assisted living care, using the money to remodel your home, or paying for expensive medical procedures.
In most cases, the interest rate on a mortgage will be a fraction of what it would be on a credit card, so using your home’s equity to offset such costs makes more sense in the long run. Plus, you may be able to lock in a lower interest rate than you had before, saving you money on your mortgage as well.
Other benefits to cash out refinancing may include…
- Interest charged on the loan may be tax deductible. The interest on a home equity loan may also be tax deductible, but the rates are typically higher.
- You’ll only have one loan and one payment. With a home equity loan, you have your mortgage, plus an additional loan against your equity.
A few of the drawbacks may include…
- Your first mortgage gets reset, possibly adding extra years to the term until it’s paid off. For example, let’s say you have 20 years left of a 30 year mortgage. You decide to do a cash out refinance, essentially replacing your current mortgage with a new 30 year mortgage. Now, the home you bought will take 40 years to repay instead of 30.
- Along with the extended term, you’ll also be faced with having an even longer period of time before you can start to significantly rebuild your equity.
Home Equity Loan
Now let’s examine the home equity loan, an alternative to the cash out refinance. With a home equity loan (HEL), your original mortgage remains the same and a new, additional loan is created with your home used as collateral. An HEL is what’s known as a closed-end loan or a second mortgage.
With HELs/second mortgages, the loan term is usually between 5 and 15 years shorter than a first mortgage and the interest rate is usually fixed, although adjustable rate HELs are offered by some lenders. The proceeds of the loan are paid to the homeowner in a one-time lump sum, similar to a cash out refinance.
The key difference between an HEL and a cash out refinance is this: an HEL consists of a second mortgage, with your home used as collateral. With a cash out refinance, you’re basically replacing your original mortgage with a new, higher loan and simply receiving the difference in cash. If you default on a cash out refinance loan, you’re essentially defaulting on your mortgage and you could face the risk of foreclosure. If you default on an HEL, your lender could foreclosure, but they typically try to avoid this because in order to foreclose on your home, they also have to pay off the home’s first mortgage. Instead, the HEL lender will usually send a certified letter informing the homeowner of their default and outlining what they must repay and when in order to avoid foreclosure or a lawsuit. If the missed payments continue, the lender could proceed with court action or foreclosure.
If you find yourself struggling to make your mortgage payments or HEL payments, our advice is to communicate with your lender immediately to try to work something out. Lenders do not want to foreclosure on your home any more than you do, and the sooner you’re honest with them about your financial situation, the sooner they may be able to work with you to find a solution. There are also independent financial counselors and even free or reduced cost foreclosure avoidance counseling in most parts of the country. Check the Department of Housing and Urban Development’s website to find a counselor in your area.
To recap, here are a few benefits of the home equity loan:
- It leaves your first mortgage alone.
- Closing and acquisition costs are often lower than those for a cash out refinance.
- Interest charged on HELs may be tax deductible.
And here are a few of the drawbacks:
- The interest rate is typically higher than those for a cash out refinance.
- Fees are often higher than for a home equity line of credit (HELOC)*
To get additional information on either of these home loan options, please feel free to contact Priority Lending Mortgage Corp to speak with one of our lending professionals.
*Similar to a home equity loan, a home equity line of credit allows the borrower to access funds as needed instead of receiving the proceeds in a lump sum. Talk to a mortgage professional for details.