As your home appreciates in value and you keep reducing your total mortgage with your monthly payments, equity (the difference between your home's value and your mortgage balance) begins to build. You can keep the equity in your home and allow it to accrue. Alternatively, you can use your home's equity if you need it. Two ways to use the equity are cash-out refinancing and home equity loans (sometimes still referred to as second mortgages).
What Is Cash-Out Refinancing?
Cash-out refinancing involves refinancing your mortgage for more than the current amount due. This overage allows you to use the extra cash for another use.
For a better understanding of cash-out refinancing consider this. Your home is worth $250,000 and you owe $175,000. You need $25,000 for home repairs. By using cash-out refinancing, you would take out a $200,000 mortgage. This would cover the existing mortgage and give you $25,000 for the home repairs.
Differences between Cash-Out Refinancing and Home Equity Loans
Both cash-out refinancing and home equity loans (or equity lines of credit) provide you with access to the equity in your home for purchases, debt consolidation or whatever you need to put the extra money towards. Also, in most cases, cash-out refinancing and taking out home equity loans are both tax-deductible debt. Those are the only two main similarities between the two.
Cash-Out Refinancing Explained
Here are the features associated with cash-out refinancing:
* Cash-out refinancing only involves one loan, meaning only one monthly payment is required.
* Cash-out refinancing requires existing mortgages to be refinanced for more money than is owed on the home (but less than the home's value) using built-up equity.
* The amount of the cash taken is added to the original loan and payments for that cash last the length of the mortgages.
* Generally cash-out refinancing offers lower interest rates than home equity loans.
Home Equity Loans Explained
Here are the features of home equity loans:
* The home loan amount can be paid in a lump sum or set up as a line of credit.
* Borrowers decide if they want to borrow all or just part of the home's equity.
* Home equity loans offer flexible repayment periods, allowing for either a shorter term with higher monthly payments or a longer term with lower payments.
* Home equity loans may allow you to borrow more money.
Home equity lines of credit have additional features. The borrower only has to pay interest on the money used, and the money can be accessed at any time without the need to reapply. Before you think about a home equity loan, use our Mortgage Payoff Calculator to show you the additional payment you’ll need to make in order to pay off your current mortgage within a specific number of years.
Choosing Between Cash-Out Refinancing and Home Equity Loans
Understanding cash-out refinancing is the first step in deciding if it is the right option for you. However, be aware of the facets of each type of loan when trying to choose between cash-out refinancing and home equity loans.
The best way to decide between cash-out refinancing and home equity loans is to determine how much money each will save you in monthly payments over the life of the loan. Cash-out refinancing will most likely give you a better interest rate and lower monthly payments. However, depending on the length of the mortgages, you may pay more in interest over time.
For example, let's suppose that Holly and Harry Homeowner currently owe $174,000 on their home, which is valued at $260,000. They originally purchased the house when mortgage interest rates were higher. Their original 30-year mortgage was for $200,000 with an interest rate of 9.95 percent. This gives them monthly mortgage payments of $1747.76 (plus taxes and insurance).
Holly and Harry want to take advantage of the drop-in interest rates and need $40,000 for a home addition. They now qualify for a rate of 6.05 percent. Here are the options available to them and the costs associated with them:
* Cash-Out Refinancing: Lower Rate 30-Year Mortgage with $40,000 Taken Out
30-year mortgage amount: $214,000 ($174,000 + $40,000) at 6.05 percent
Monthly payments: $1,289.93
Overall interest paid: $250,373.16
Total amount paid over 30 years: $464,373.16
* Refinance at Lower Rate with No Cash Take: Get Home Equity Loan for $40,000
30-year mortgage amount: $174,000 at 6.05 percent
20-year home equity loan amount: $40,000 at 7.39 percent
Monthly mortgage payments: $1048.82
Monthly home equity payments: $319.55
Total monthly payments: $1,368.37
Mortgage interest paid: $203,574.44
Home equity loan interest paid: $36,692.53
Total overall interest paid: $240,266.97
Total amount paid over 30 years: $454,266.97
By comparing the monthly payments, Holly and Harry will have to pay $78.44 more per month with the home equity loan. But, looking at the overall amount paid, they will pay $10,000 more over 30 years by selecting the cash-out refinancing.
Therefore, when deciding whether cash-out refinancing or home equity loans are the better choice for you, you need to decide if you want short-term relief or long-term savings.
If cash-out refinancing causes your mortgage to go over 80 percent of your home's value, you will have the added cost of private mortgage insurance (PMI). PMI is not required for home equity loans. Also, don't forget to figure in the closing costs associated with cash-out refinancing that are not required for home equity loans.
