Having equity in your home can be a valuable source of needed cash. Whether you should use a home equity loan or a cash-out refinance to access that equity depends on a number of factors.
For many homeowners, home equity is equivalent to having a large savings account. You can build equity in your home in two ways: (1) when it increases in market value, and (2) when you pay down your mortgage. Getting your hands on that accumulated equity is another issue. You can do that either by selling the property-not a great choice if you're living there-or by borrowing against it.
For example, let's say you have a home worth $250,000, and you owe $150,000 on the mortgage. That means you have $100,000 of equity in your home, which is like having $100,000 in savings. One option is to keep your original first mortgage, and take out a second mortgage or home equity loan (the terms are synonymous) for the amount of equity that you'd like to withdraw.
Another strategy is to use a cash-out refinance. In this scenario, you refinance your first mortgage, and take out a new one for more money than you currently owe on your home. You then pay off your first mortgage and pocket the difference. Using the above example, you could refinance $175,000, pay off the loan balance of $150,000, and pocket a cool $25,000.
Understanding the differences
Since the characteristics of the two types of loans differ significantly, it helps to understand the pros and cons of using a cash-out refinance versus a home equity loan.
- The interest rates on home equity loans are usually higher than refinance rates-but you'll generally pay substantial closing costs to refinance. Closing costs for home equity loans are usually insignificant.
- If you need the money in a hurry, a home equity loan can close within a week, whereas a refinance can usually take a month or longer.
- When refinancing, you'll probably pay back the loan in 15 or 30 years. Your monthly payments will be smaller, but you'll pay a lot more interest over time. With a home equity loan, you have more flexibility and can take advantage of a shorter term to reduce the amount of interest you'll pay over the life of the loan.
For most homeowners, a home equity loan is best for short-term loans that you can pay back within two to three years. Why pay 30 years of interest through refinancing in order to buy a $3,000 high-definition TV, for example, when you could use a convenient home equity loan? But for bigger expenditures-like a $50,000 remodeling job in the kitchen-you might enjoy paying the loan back slowly over decades with a cash-out refinance. Another good reason to refinance: If you're stuck in an expensive adjustable-rate mortgage, you can switch to a lower fixed rate while simultaneously doing a cash-out, in order to accomplish two financial objectives at once.