Homeownership

Is a Cash-Out Refinance or a Home Equity Loan Best for you?

By Noah - Nov 18th, 2020
Comparing a cash out refinance vs. a home equity loan If you’re planning a big purchase your bank account won't cover, like home renovations or a child's education, you need an alternative way to get cash in hand.  Or, perhaps you're facing bills your emergency fund won’t cover.   For many Americans, their home is the single largest asset in their portfolio.  There are a lot of ways to tap into your home equity to create some financial breathing room, but they have different pros and cons.  If you find yourself faced with this personal finance decision, are you better off taking out a cash-out refinance, a home equity loan, or another form of home financing entirely?
What is a Cash-Out Refinance?
Like many forms of home loans, refinancing revolves around how much of your home's value you own – your home equity.  Simply put, when approved for a cash-out refinance, a bank allows you to exchange some of that home equity for cash, in exchange for a new interest rate and overall balance.  Because a cash-out refinance generally requires the homeowner to own a large percentage of their home's equity, it's an option that is available to homeowners who have lived in their home for many years. In practice, here's how the numbers for a sample transaction might play out.  Imagine that you own a $500,000 home with $400,000 already paid off and $100,000 remaining in monthly mortgage payments.  You're overdue for a kitchen remodel, but need $40,000 to pay for the improvements.  You decide to take out a cash-out refinance to cover the gap in your budget, replacing your original mortgage with a new one.  You now owe $147,000 on your current mortgage ($140,000 loan amount plus fees at 5%) and have a check for $40,000 left to spend on your home improvements. Typically, cash-out refinancing can be used for any purpose, but some lenders will only supply a ‘limited’ cash-out refinance, meaning it can only be used for certain purposes.  These limitations are generally related to your home itself, meaning the lender would not approve a cash-out refinance for uses like student loans, credit card debt, or medical bills.
Requirements for a Cash-Out Refi
As with any large-scale financial decision, you'll have to meet some requirements in order to qualify for a cash-out refinance.  Since this type of home loan requires monthly payments, your lenders' number one concern will be your ability to pay them back.  They'll review your financial profile to see:
  • Is your credit score high enough?  The minimum credit score is generally higher for cash-out refinancing than it is for a regular fixed-rate mortgage. For example, you may only need a 580 to refinance, but 620 to take cash out.

  • Is your debt-to-income ratio low enough?  Your DTI ratio, calculated as monthly bills divided by monthly income, must be less than 50%.  Lenders will likely ask for documents like bank statements and W-2s to verify this ratio.

  • Do you have enough home equity? Generally, you don’t want to dip below 20% equity in your home.  If you need to borrow more than 80% of your home’s value, your lender will likely require you to take out private mortgage insurance, which will add to your monthly costs.

Getting Approved for a Cash-out Refinance
Once you’ve determined how much money you need, the search for a lender begins!  Request a quote from an NMLS lender (verifying that they are a licensed mortgage lender according to national standards) and be ready to provide additional documentation to confirm you meet their requirements.   Cash-out refinances are available with either a fixed or an adjustable rate, but while the Fed continues to lower interest rates, mortgage rates are currently at an all time low.  You may find the fixed rate is a better option for your financial situation than a variable rate.  That being said, along with greater uncertainty due to the pandemic, major banks have tightened their lending standards, making it even harder to qualify for a cash-out refinance.  Closing costs for a cash-out refinance are generally higher than home equity loans or a home equity line of credit.  But if your new interest rate is lower than your first mortgage, you may find that the one time costs of a cash-out refinance balance out your savings in interest.
Risks of a Cash-Out Refinance
If you’re not confident that your home will increase in value over the course of your loan term, typically 10-30 years, a cash-out refinance may not be your best option.  The bank will still require repayment of the full balance of your new mortgage – even if the value of your home decreases over time- leaving you potentially "underwater." If you're nearing retirement, it's also important to take your new loan term into consideration.  Even if your home value increases over time, a 30 year cash-out refinance taken out at 65 years old won't be paid off until you're 95 – potentially impacting your ability to leave it to your heirs. If a cash-out refinance doesn't sound like the best fit for you, it's worth comparing against another popular home financing option – a home equity loan.
How does a home equity loan work?
Home equity loans allow borrowers who have paid down a significant portion of their mortgage to access their home equity.  Sometimes referred to as a second mortgage, these loans are one of the most common forms of home financing. When you obtain a home equity loan, a lender will provide you a lump sum which you will repay over time in monthly installments that include accrued interest.  Unlike a cash-out refinance that replaces your existing mortgage with a new one, a home equity loan is considered a second lien on your home. Home equity loans generally have a higher interest rate than other traditional financing options like HELOCs, which some homeowners view as a fair tradeoff in exchange for a fixed interest rate and predictable second mortgage payments.
Requirements for a Home Equity Loan
Similar to a cash-out refinance, your credit score, your debt-to-income ratio, your income, and the amount of home equity you own all matter when you apply for a home equity loan. Lenders need to feel confident that you’ll be able to repay the loan.
Getting Approved for a Home Equity Loan
When a lender reviews your application for a fixed-rate home equity loan, they'll first review your loan-to-value ratio to make sure you have enough equity in the home to take out a second mortgage.  They’ll also review your financial profile to make sure you have the documented ability to repay your new loan.  If you are not a W2 employee and have a non-traditional income source, you may have to provide additional documentation to prove to the lender that you have the ability to make your monthly payments over the term of the loan, typically 30 years.   While the minimum credit score is lower for home equity loans than some other forms of financing, the higher your credit score, the more likely it is that you’ll qualify for the best rates.
Risks of a Home Equity Loan
Similar to a cash-out refinance, or any other type of home financing that includes interest, it’s worthwhile to calculate the impact your loan length will have on your overall costs over time.   Over 30 years, interest payments can add up quickly – and some lenders may charge a prepayment penalty if you come into a windfall, your income increases significantly, or generally have the ability to pay the loan back earlier than scheduled. Finally, as with all home financing options, tread carefully if you’re using your home equity loan to pay off unsecured debt.  Financial advisors generally recommend against replacing unsecured debt like credit card bills with secured debt like a HELOC or home equity loan unless you have a solid plan to avoid future debt.
Cash out refinance vs. home equity loan
Cash-out refiance
Home equity loan
Cash-out refiance
Home equity loan
Credit score min
580
620
Credit score min
580
620
DTI ratio
43%
43%
DTI ratio
43%
43%
LTV ratio
80%
80%
LTV ratio
80%
80%
Closing costs
2%-5%
2%-5%
Closing costs
2%-5%
2%-5%
Interest rate
3.9%-4.5%
6%-14%
Interest rate
3.9%-4.5%
6%-14%
Monthly payments
Yes
Yes
Monthly payments
Yes
Yes
Home Value Investments
Homeowners shouldn't limit their research to cash out refinancing vs. home equity loans. If you want to avoid adding to your monthly debt burden, you may find that a Home Value Investment is the best option for their financial situation.  An alternative to cash-out refinancing and second mortgages, home equity sharing is an innovative type of home financing that doesn't add to your debt balance.  Companies like Noah provide upfront financing, called a Home Value Investment, that allows you to access the equity in your home, while completely eliminating monthly payments and added interest.   Unlike a home equity loan, a Home Value Investment has no prepayment penalties if you're able to pay Noah before your 10 year repayment period ends.  And in stark contrast to a cash-out refinance, home equity sharing doesn't increase your mortgage payment.  Plus, if your home loses value over the length of your investment term, Noah shares in the loss of value alongside you – unlike cash-out refinancing lenders. Get a free quote from Noah today, without any impact to your credit score.  We'll instantly tell you the maximum amount of funding you may be eligible for with a Home Value Investment.