If you need some money to consolidate other debts or cover a large unexpected expense, using your home’s equity may be your best option because home loans usually have lower interest rates than credit cards or many personal loans.
But are you better off with a home equity loan, or should you consider a cash-out refinance? There are some key differences. Here’s what you need to know before you decide.
|Cash-out refi||Home equity loan||Home equity line of credit (HELOC)|
|What’s the difference||Pays out some of your home’s existing equity in cash, resulting in a new mortgage||The loan is based on your home equity; it is in addition to your current mortgage||Revolving line of credit based on your home’s equity. You don’t need to use all of it at once. Instead, you have a “draw period,” usually ten years|
|Interest rate||Can be fixed or adjustable rate||Can be fixed or adjustable rate||Variable rate|
|How much can you borrow?||80% of your home’s value unless you have a VA loan, in which case you can borrow up to 90%||80-85% of your home’s value minus what you owe on your mortgage||75% of total loan-to-value (LTV) is standard.|
|Main Pro||Rolls all of your debts into one loan||Allows you to borrow money at lower interest rates than most personal loans charge||Flexibility|
|Main Con||Closing costs can be more than $5,000||You could end up owing more than your home is worth if home values fall||There may be minimum withdrawal requirements|
|Credit score requirement||640 to qualify for the best loans||620, though you may be able to qualify with a score as low as 500, you’ll pay higher interest rates||620|
|Payments||One monthly payment||Two monthly payments||Two payments when you’re making payments to the HELOC|
|Documents required||Property appraisal,|
W2s, tax returns, pay stubs,
proof of homeowner’s insurance,
documentation of any outstanding debts you owe,
driver’s license or government ID,
cashier’s check for the balance of the mortgage
|Property appraisal, proof of income, Social Security number, documentation of any outstanding debts you owe, mortgage statement, property tax bill, proof of homeowner’s insurance||Pay stubs, bank statements, proof of income, proof of homeowner’s insurance, mortgage statement,|
property tax bill
|Best for:||People planning to remain in their current home for a long period and who need a large sum of cash||People with lower credit scores and those who want to avoid the high closing costs of a new mortgage||People who don’t need a large amount of money now but need the flexibility to borrow a larger amount in the future|
For all three options, you’ll need to know your home’s value and documents showing your household income, Social Security number, and any other outstanding balances. Lenders also will ask for a mortgage statement, a property tax bill, and a copy of your homeowner’s insurance policy.
This means you refinance your current mortgage with a larger mortgage, borrowing more than what you owe on the original mortgage. You aren’t simply taking out a loan against your home’s equity. Instead, you’re getting an entirely new mortgage. You pocket the difference once your original mortgage has been paid.
You still have to collect all the documentation needed for a mortgage.
How it Works
Some lenders will allow you to borrow 100% of the equity on your house — or sometimes even more. For example, let’s say your mortgage balance is $100,000 on a $200,000 house. This means you have $100,000 of home equity. With a cash-out refinance, you could borrow $150,000, pay off your original mortgage with the proceeds from the cash-out refinance, and have $50,000 for debt consolidation or home improvements.
Other lenders cap the loan-to-value ratio (LTV) at 80%. The totals also can vary depending on whether you have a conventional mortgage, an FHA loan, or one through the VA.
Why Get a Cash-Out Refinance
Most people use cash-out refinancing to pay for home improvements they might not otherwise be able to afford (foundation slab leaks, new air conditioners, kitchen and bathroom remodels, etc.) These boost the value of the house and add equity, and in some instances, are repairs that cannot be delayed while you build savings. Another reason for a cash-out would be to consolidate debts or pay college tuition.
Should you consider a cash-out refinance? Check out this video to learn more:
Pros and Cons of Cash-Out Refinance
From IRS implications to closing costs, there are several pros and cons of cash-out refinancing.
- You can borrow a significant amount cash with a better interest rate than most personal loans.
- It’s easier to qualify for these compared to other loans because you already own the property
- One monthly payment
- Interest could be tax deductible
- You could switch to a fixed rate if you have an adjustable-rate mortgage.
- You can qualify with a lower credit score because you are already in the home
READ MORE: Is my home equity loan tax deductible?
- You’ll have to gather many documents, including taxes, salary, and bank statements
- Closing costs can be steep
- If the value of your home falls, you could end up owing more than your home is worth
- Your credit score will matter
- There’s a risk of foreclosure if you can’t keep up with the payments
- Current mortgage rates are high right now. The higher interest rate will cost you significantly more over the life of the loan
READ MORE: Can you refinance a paid-off home?
Home Equity Loan
Home equity loans are also sometimes referred to as a second mortgage. With these loans, you are using your home’s equity as loan collateral. The lender provides the loan proceeds in a lump sum, reducing your equity amount. As you repay your loan, your equity will increase.
You will essentially have two mortgage payments each month. You’ll also have to pay any costs upfront, including escrow funds.
Because your home’s value secures the loan, these loans have lower interest rates than personal or installment loans. These loans usually have slightly lower interest rates than a home equity line of credit. You’ll also have a fixed repayment period.
Equity requirements vary, but most lenders require a minimum of 15% to 20% equity in your home.
READ MORE: Can you refinance a home equity loan?
Home Equity Line of Credit (HELOC)
A HELOC is a revolving line of credit based on your home’s equity. The loan will have a fixed draw period, usually ten years. They typically have a variable interest rate. However, you only have to pay interest on the amount you use.
HELOCs are a more flexible line of credit. Borrowers are more likely to use them to pay for costs like college tuition or other significant expenses that may not be tied to home improvements.
A note about FHA loans and VA loans: These types of loans have different rules. The VA and FHA do not issue home equity loans. Instead, if you require a VA- or FHA-backed loan, you must choose a cash-out to refinance. Otherwise, you can apply for a conventional home equity loan or home equity line of credit.
There are two main reasons:
- There will be a lower overall mortgage cost
- It will release equity that is otherwise tied up in your house
What if I Have Bad Credit?
It varies by lender, but getting a home equity loan will usually be easier if your credit score is less than perfect. A cash-out refinance traditionally requires a credit score of around 640 but could be lower. When you borrow against your home’s equity, lenders tend to be more forgiving of less-than-stellar credit. Lenders will check your debt-to-income ratio to ensure that you can make the payments.
Watch out for emails and letters offering “streamlined” cash-out refinancing for your existing mortgage. Be sure to get estimates from other lenders, and pay close attention to interest rates. If a lender is offering you a bargain on closing costs, you’re probably paying for it in higher interest rates or other fees.
Refinance Reality Check
A refinance right now will almost certainly not save you money. Mortgage rates have doubled during 2022, and though a refinance could mean lower monthly payments, you will almost certainly end up paying significantly more over the life of the loan.
For example, refinancing from a 3% mortgage with 20 years left to a 5% rate for 30 years may lower your monthly payment but will cost thousands of dollars in additional interest.
A home equity loan is probably a better deal unless you have an adjustable-rate mortgage or you’ve improved your credit score since you purchased your home. Otherwise, you’re better off waiting to try a cash-out refinance when rates are lower.
READ MORE: Is a home equity loan a good idea?
Other Types of Loans
If you don’t want to use a home equity loan or refinance your mortgage, you have a few other loan options:
The Bottom Line
Americans are sitting on a lot of home equity, thanks partly to the hot real estate market over the past five years. The good thing is you don’t have to sell your home to take advantage of this.
Whether you get a cash-out to refinance, consider the first loan, or a home equity loan, it is essential to understand the key differences to make the right choice. But, as with any loan decision, you should not take borrowing money lightly, and your justification for taking out a loan should begin with a fiscally responsible one.
Refinancing is replacing an old loan with a new one. You will want to be in the home long enough to justify closing costs. There are several reasons why homeowners choose to refinance.
Rates on cash-out refinancing tend to be lower than home equity loans. It’s important to note that while the interest rate is lower, the amount financed may be much higher because a cash-out refinance will pay off the first mortgage. Study each scenario because sometimes a home equity loan is a much better option.
VA cash-out refinances requirements vary by lender, loan amount, credit score, and more. What is important is you must meet VA service requirements for VA loan eligibility. VA lenders often look for a minimum credit score of at least 620 for cash-out refinances. You must certify that the property will be owner-occupied before being refinanced.
You will need to get a Certificate of Eligibility for a VA direct or VA-backed home loan stating you meet the minimum active-duty service requirement based on when you served.
For service members: If you’ve served for at least 90 continuous days (all at once, without a break in service), you meet the minimum active-duty service requirement.
If you are a veteran: The minimum active-duty service requirements depend on when you served. See VA eligibility refi eligibility requirements to learn more.
Generally, you will have to pay the VA funding fee. This is a one-time payment that the veteran, service member, or survivor pays on a VA-backed or VA-direct home loan. This fee helps lower the loan cost for U.S. taxpayers since the VA home loan program doesn’t require down payments or monthly mortgage insurance. If you’re using a VA home loan to buy, build, improve, or repair a home or to refinance a mortgage, you’ll need to pay the VA funding fee unless you meet specific requirements.
To qualify for an FHA cash-out refinance, you must have the following:
A credit score of at least 600 (with most lenders), but some will do it for a 580
The borrower has to have a debt-to-income ratio below 43% for total fixed payments to effective income. Add up the entire mortgage payment (principal and interest, escrow payments for taxes, hazard insurance, mortgage insurance premium, homeowners’ association dues, etc.) and all recurring monthly expenses and installment debt (car loans, personal loans, student loans, credit cards, etc.) and dividing this by your gross monthly income.
More than 20% equity in the home loans or have a maximum loan-to-value of 80 percent of the home’s current value. The LTV ratio is calculated by dividing the loan amount requested by the property value determined in the appraisal.
On-time mortgage payments for the past 12 months with documentation or since the borrower obtained the loan, whichever is less. Mortgaged properties must have a minimum of 6 months of payments made before you can apply for a refinance.