Home Equity Loan vs. Cash-Out Refinance Roger Odoardi Home equity loans and cash-out refinancing both serve the same purpose: enabling homeowners to secure funding for major expenses. This could include home improvement projects, medical bills, college tuition, high-interest debt and more. Pursuing one of these options can help you unlock better loan terms, including lower interest rates, which in turn can allow you to gain more financial stability. Both options come with advantages and disadvantages that vary based upon an individual’s unique situation. So how can you determine which one is right for you? In this article, we cover the differences between cash-out refinancing and home equity loans to help homeowners understand which will best suit their specific needs. What is Home Equity? One of the most significant benefits of investing in a house is the ability to start building home equity. Home equity can be defined as the value of ownership stake in your home. In other words, it is the difference between the current market value of your home and the total amount still owed on your mortgage. How to Find Out Your Home Equity You can calculate your home equity by subtracting your outstanding mortgage balance from the current fair market value of your home. For example, if your home was recently appraised at $300,000 and you still owe $140,000 on your mortgage, your home equity is $160,000. What is a Home Equity Loan? A home equity loan is a form of a second mortgage that allows you to borrow a specific amount without affecting your existing mortgage. If you can get approved, a lender will determine how much money you can borrow based on your home’s value and any debts against you. The bank will present that amount to you in a lump sum, which you must then repay at a fixed rate over a period ranging from 5 to 30 years. If you default on your home equity mortgage, the lender reserves the right to take possession of your home. How Do I Qualify for a Home Equity Loan? Some lenders may allow you to borrow up to 85% to 90% of your home’s value based on the combined loan-to-value ratio (CLTV). The CLVT is calculated by adding up all mortgage debt and dividing the total by the home’s current appraised value. According the Bankrate, the formula is as follows: (Amount owed on primary mortgage + Second mortgage) / Appraised value Requirements to qualify for a home equity loan vary from lender to lender, but typically include the following: A credit score of 620 or higher More than 20 percent equity A loan-to-value ratio (LTV) of 80 percent or below, as determined by an appraiser A low debt-to-income (DTI) ratio Stable credit and bill repayment history Income and asset verification documentation What is a Home Equity Line of Credit? Similar to a credit card, a home equity line of credit (HELOC) works as a revolving line of credit that you can borrow from when necessary. A HELOC enables you to access the loaned funds at any time you choose rather than all at once. HELOC is a good option if you need money for other items, such as college or paying down high-interest credit card debt. HELOCs operate on adjustable interest rates, and the repayment period is about 10-20 years. With a HELOC, you can borrow during the “draw period,” which is usually 5-15 years. During this draw period, the monthly payment is usually interest-only, which allows for a more affordable monthly payment. Since mortgage interest rates are tax deductible, a HELOC could lower your taxable income and help you secure a larger tax refund. What is a Cash-Out Refinance? Cash-out refinancing is used to leverage your home’s equity by borrowing more money than is owed on your existing mortgage to receive the difference in cash. In other words, you replace your existing mortgage with one that is of higher value. With cash-out refinancing, you get to decide how to use the money that is borrowed against the value of your home. The cash can be used to secure funding for major expenses, such as home improvement projects, medical bills, college tuition, high-interest debt and more. How Do I Qualify for Cash-Out Refinance? There are three main cash-out refinancing loan programs that each have their own requirements. Conventional cash-out: Available to homeowners with high credit scores or who have more than 20 percent equity Borrowing amount is capped at 80% of the home’s value VA cash-out: Available for U.S. veterans and active service members, who can receive up to 100% of their home’s value in cash Eligible veterans can receive up to 100% of their home’s value (however, industry experts recommend that borrowers do not cash out more than 90% of their equity) FHA cash-out: Available to homeowners with lower credit scores or who have more than 15 percent equity Good for those who have experienced bankruptcy within the last few years Borrowing amount is capped at 80% of the home’s value Since a cash-out refinance is a new mortgage, all the standard application requirements apply. To qualify, homeowners should meet the following standard criteria: Have owned the home for at least six months to one year (depending on the loan program) A credit score of 620 or higher (varies from lender to lender) More than 20% equity/an LTV of 80% or below A low debt-to-income (DTI) ratio Stable credit and bill repayment history Income and asset verification documentation Key Differences Between Cash-Out Refinances and Home Equity Loans Home Equity HELOC Cash-Out Refinancing Replaces Current Mortgage No – home equity is a second mortgage No Yes Interest Rates Often fixed Adjustable Fixed or variable – typically lower Fixed Monthly Payments Yes No – interest-only payments during the draw period Yes Repayment Period 5 to 30 years 10 to 20 years 15 to 30 years How Will My Credit Score Be Impacted? Because each loan type provides some form of credit to a borrower, there is no doubt that mortgage re-financing can impact credit score. A home equity loan or HELOC can either help or hinder your credit score. Regardless of whether you make your payments on time, using all the available credit will indicate high risk and subsequently have a negative impact on your credit score. On the other hand, if you use your HELOC strategically and consistently make payments over time, you can expect to see a boost in your credit score. With cash-out refinancing, there are three unfavorable outcomes that can result regarding your credit score. First, the replacement of old debt with a new loan (and thus new debt) can lower your credit score. Second, a larger loan balance could in turn increase your credit utilization ratio. In other words, an increase in the percentage of a borrower’s total available credit that is being utilized can potentially lower credit score. Finally, your application submission for a cash-out refinance will trigger a “hard inquiry” when the lender checks your credit report. A hard inquiry will temporarily cause a slight drop in your credit score. Which Loan Type is Right for Me? There are two primary considerations to make when deciding which option suits you best. Start by asking yourself: How will I use this money? If you have planned expenses such as home renovations or paying college tuition, the answer is cash-out refinancing. If you are trying to create a safety net for unexpected financial burdens, the answer is a home equity mortgage. Next, ask yourself: Am I able to pay off the loan in the next six months? Although a cash-out refinance has a higher upfront cost than a home equity mortgage, cash-out refinancing comes with lower out-of-pocket monthly payment expenses, making it the more affordable option for the long run. If you believe that you’ll realistically be able to pay off your loan in the span of six months, consider a home equity mortgage to save on upfront costs. Below is a breakdown of how to know which loan type is right for you. Home equity loan is recommended if: You want to leverage a large portion of your home’s market value You know the exact amount needed and you need it right away You want predictable monthly payments You can afford to make a second mortgage payment each month You want access to home equity without changing terms of your mortgage Interest rates are low HELOC is recommended if: You have ongoing projects You want an extra source of emergency funds You are equipped to pay back what you use in a timely manner Cash-out refinancing is recommended if: You have a good amount of equity in your home You qualify for a lower interest rate than your existing mortgage You are planning to live in your home for the next several years You are planning to use the cash for financially beneficial purposes, such as paying off debts or increasing the value of your home Before you decide between a home equity loan and cash-out refinancing, it’s best to speak with a mortgage industry expert. At Blue Water, we make it our mission to help homeowners determine the best loan and refinancing option for their situation. Reach out to a member of our team today to start the conversation about how our team can help you achieve your refinancing goals. Blue Water Mortgage is licensed in New Hampshire, Maine, Massachusetts, Connecticut, Florida, and North Carolina. Roger Odoardi Roger is an owner and licensed Loan Officer at the Blue Water Mortgage office in Hampton, NH. Roger graduated from the University of New Hampshire Whittemore School of Business and has been in the mortgage industry for over 20 years. Roger has originated over 2500 residential loans and is licensed in New Hampshire, Massachusetts, Maine, Connecticut and Florida.