Refinancing vs. Home Equity Loan: What’s the Difference?

When you refinance a mortgage, you take out a new loan to pay off the old one. You then make payments toward the new loan going forward. This can make sense when interest rates drop if you have good credit. For example, refinancing originations reached $2.6 trillion in 2020 as interest rates hit near historic lows.

A cash-out refinance is a specific type of refinance loan that allows you to borrow against the equity in your home. Your new loan replaces your original first mortgage and you receive cash at closing. 

Cash-out refinance loans have closing costs, just like any other type of mortgage loan. The amount you can borrow can depend on how much equity you have in the home. Typically, lenders allow you to borrow 80% to 85% of the home’s value. 

Here’s an example of how a cash-out refinance loan works: Say your home is worth $350,000. If a lender caps cash-out refinance loans at 80% of the home’s value, you’d be able to borrow up to $280,000 against it. If you owe $250,000 on your current mortgage, you’d be able to receive $30,000 from the new loan in cash. 

Cash-out refinance pros

• Get cash to pay for debt consolidation, home improvements or repairs, medical expenses, or other financial needs. 
• Loan interest is tax-deductible when used to pay for home repairs.
• Choose between 15- or 30-year loan terms and fixed or variable rates.

Cash-out refinance cons

• Monthly mortgage payments may increase since your new loan will be more than what you owed on the previous one.
• Good to excellent credit is required to get the best interest rates on a cash-out refinance loan.
• Home equity is diminished since you’re borrowing against it. 

A home equity loan is also a loan that allows you to borrow against your equity. But it’s not exactly the same as a cash-out refinance. 

With a home equity loan, you’re not replacing your current mortgage. Instead, you’re taking out a new second mortgage that’s based on the amount of equity you’re borrowing against. Lenders may allow you to borrow up to 90% of your home’s value for a home equity loan. 

So going back to the previous example of a home valued at $350,000, you’d be able to borrow up to $315,000. If you owe $250,000 on the mortgage, you could borrow $65,000 in equity, which is quite a bit more than what you could get with a cash-out refinance loan. 

You still get a lump sum of money at closing that you can use to pay for home repairs or improvements, consolidate debt, or cover other expenses. But the interest rate on your first mortgage doesn’t change. And you’ll now have two mortgage payments to make each month going forward, versus one. 

Home equity loans are often grouped together with home equity lines of credit or HELOCs. But they’re not identical either. With a home equity loan, you receive a lump sum of money. A HELOC is a line of credit you can draw against as needed. 

Home equity loans tend to have fixed interest rates while home equity lines of credit may have variable interest rates. This means your interest rate can go up or down over time, which can affect your monthly payments. 

Home equity loan pros

• Fixed interest rates can offer predictability, since payments stay the same over the life of the loan.
• Potentially borrow more of your home equity than you could with a cash-out refinance loan. 
• Interest may be tax-deductible when the money is used for home improvements. 

Home equity loan cons

• May have higher interest rates than home equity lines of credit. 
• Failing to pay a home equity loan could lead to a foreclosure proceeding since the home is used as collateral. 
• Two mortgage payments to make each month could put a strain on your budget. 

Home equity loans, HELOCs, and cash-out refinancing can all serve the same purpose: allowing you to tap the equity into your home. But it’s important to remember that they don’t all work the same way when comparing the options. 

Cash-out refinance vs. HELOC

A cash-out refinance loan could be attractive if you want to try to get a lower rate on your mortgage debt while taking cash out. On the other hand, you might prefer a HELOC if you don’t necessarily need a lump sum of cash right away. 

If you’re looking at a cash-out refinance vs. HELOC side by side, here are the main differences to note.

Home equity loan vs. refinancing cash-out

Whether it makes sense to choose a home equity loan vs. refinance loan can depend on your goals and what you need the money for. So what are the advantages of home equity loan vs. refinancing? 

In a nutshell, getting a home equity loan could be a good fit if you’re comfortable with having two mortgage payments and you want to borrow at a fixed interest rate. It’s also possible that you could take out more of your home’s equity with a home equity loan vs. refinancing cash out. 

Home equity loan vs. HELOC

A home equity loan could be a good fit if you want to get a lump sum of money. On the other hand, you might choose a HELOC if you only want to pay interest on the amount of your credit line you’re actually using. 

If you own a home, then you could have a ready source of cash available if you’ve built up some equity. Understanding the advantage of a home equity loan vs. refinancing or HELOC can help you decide on the best way to use that equity. Keep in mind that the interest rates you’ll pay for a home equity loan, cash out refinance loan, or HELOC can depend on your credit scores, income, and how much you owe on the home. And if you’re still renting, consider the benefits of owning a home instead.