Cash-out refinance vs. home equity loan: How to choose

As you pay down your mortgage and your home's value increases, you build equity, which is the difference between what you owe on the home and what it's worth. There are different ways you may be able to use that equity: for a renovation, to consolidate high-interest unsecured debt, or to cover a major expense. 

A cash-out refinance and a home equity loan are two of the most common ways to tap equity in your home. Both give you access to a lump sum of cash you can use for just about any expense, and both are secured by your home.  

Either one could help you reach your financial goals.The right choice depends on whether you're more interested in replacing your current mortgage with a new one, or taking on a second mortgage.

How a cash-out refinance works

With a cash-out refinance, you take out a new mortgage for more than you owe on your existing mortgage. Your lender closes out the old loan, opens the new one, and issues you the difference, which represents your equity, in cash at closing. From that point on, you have one mortgage payment on the new, larger loan.

Say your home is worth $400,000 and you still owe $200,000. You could refinance into a new $275,000 loan and receive $75,000 in cash (minus closing costs). Your monthly payment may increase, since the new loan balance is higher. The new loan's interest rate and repayment term also influence your payment amount.

Closing costs for a cash-out refinance typically range from 2% to 5% of the loan amount, similar to any other mortgage. Most lenders require you to keep at least 20% equity in your home after the refinance, which generally limits the loan to around 80% of your home's value.

How a home equity loan works

A home equity loan is a second mortgage. Your original loan remains in place, as it is. You receive a one-time payment and repay it at a fixed rate over a separate term, typically between 5 and 30 years.

Using the previous example, if your home is worth $400,000 and you owe $200,000, you have $200,000 in equity in your home. You may be able to borrow against a portion of that equity through a home equity loan. You'd keep your current mortgage payment and add a second payment on the new loan.

A home equity loan sits in second position behind your first mortgage, which means that in the case of foreclosure, the home equity lender gets paid after the first mortgage lender. If there’s not enough from the sale of your home to cover both mortgages, the home equity lender may not recover all the money that was lent. Home equity lenders take on more risk, and that risk is reflected in a higher interest rate than you'd get with a cash-out refinance.

Key differences at a glance

How interest rates compare

Interest rates on a cash-out refinance are generally lower than on a home equity loan. A cash-out refinance lender holds the first mortgage and has the primary claim on your home when it’s sold. That means they get repaid first with the money from the sale. A home equity loan lender is in second position. That means they get repaid second, if there’s enough money left. Lenders typically price that added risk into the rate.

Even so, the rate comparison is not always straightforward. If you locked in a low mortgage rate several years ago, a cash-out refinance at today's rates could increase your total interest cost over time, even if the new rate seems competitive. In that situation, a home equity loan with a higher rate could result in a lower overall cost, since your original low-rate mortgage stays in place.

Home equity to consolidate unsecured debt

Some homeowners consider both a cash-out refinance and a home equity loan to consolidate high-interest unsecured debt, like credit cards, personal loans, or medical bills. Both a cash-out refinance and a home equity loan could reduce the interest rate on that debt, since home-secured loans generally carry lower rates than unsecured borrowing.

When a cash-out refinance may make more sense

A cash-out refinance makes sense when your current mortgage rate is higher than today's rates. If you refinance in that scenario, you could lower your rate across the full loan balance and get access to cash.

It may also be a stronger fit if you want a single monthly payment, or if you need a larger sum and the lower rate justifies the higher closing costs.

When a home equity loan may make more sense

A home equity loan tends to be a stronger option when your existing mortgage rate is low and you want to keep it. You get access to a specific one-time payment at a fixed rate, your original mortgage is untouched, and you may avoid the closing costs that come with a full refinance.

This option generally works well for borrowers with a clear one-time need and a stable repayment plan. A home equity loan calculator can help you estimate what your payment might be. You can compare the combined payments for your first mortgage and a home equity loan to what you might pay for a cash-out refinance to determine which one is more affordable for your budget.