Comparing a Cash-Out Refinance and a Home Equity Line of Credit

A cash out refinance loan allows you to refinance your home mortgage and take equity out of your home. But if you need cash, is that a better option than a home equity line of credit, where you borrow against the equity in your home? The following information can help you evaluate these methods of accessing the equity in your home.

How They Work

In both a cash out refinance loan and a home equity line of credit you must have equity in your home, that is, the value of your home must be higher than the current balance of the loan. And, you must be able to qualify for whichever loan you choose.

Cash out refinance means you take a new loan on your home that is more than the remaining balance on your original mortgage. The refinance loan pays off the existing balance, and you pocket the difference.

With a home equity line of credit, your first mortgage stays in place. You take another loan out that is equal to about 75 to 80 percent of the equity in your home. The loan becomes a second lien against your property.  You don't have the cash in hand. The line of credit allows you to draw money out of a credit card as required for a given period of time. The most common "draw periods," as they are termed, are for 5 and 10 years.

Cash Out Benefits

First, as with any refinance, the goal is to replace your existing mortgage with a loan that has a lower interest rate. Both loans work to lower your monthly payment. Once the loan is acquired, you will only have one loan to repay.

Second, with a cash out refinance you get what can be a large sum of money for immediate use.  You can use it to buy a a big-ticket item, pay down debt or to improve your home. You borrow once, roll the payment in a new loan and are done.

Cash Out Drawbacks

A primary drawback of a cash out refinance is you will have to pay closing costs again.

There are a few more risks involved as well. First, is Private Mortgage Insurance. If you had more than 20 percent equity in your home, that is if the balance of your loan was less than 80 percent of your home's current market value, you no longer have to pay PMI. If the cash out refinance loan, which is always larger than the current balance on your first mortgage, pushes that balance above 80 percent of your home's value, you will again have to pay PMI.

Second, it is also possible that your new loan amount could be larger than the original balance on your first mortgage. If so, that could offset the benefits of lower interest rates.

Third, the repayment terms can be longer than the original loan racking up fees in the loan.  For example, you can refinance a loan that only had 15 years remaining to a new 30 year mortgage.

Lastly, with a cash our refinance, you take out all of the cash, whether you need it or not.  You are paying interest on the entire amount, no matter what.

Home Equity Benefits

With a home equity line of credit, you withdraw funds and pay interest on only the borrowed amount.  The remaining equity stays in your home and loan amount and can be used as collateral again in the future. The equity line lets you keep your equity and put it to work for you. Additionally, the fees associated with lines of credit are not as high as cash out refinances because they are second liens.

Home Equity Drawbacks

Your payment will be higher because the rates tend to be higher on second mortgages, as compared to first liens.  Additionally, these products are tied to Adjustable Rates and can be volatile.  If market conditions have high rates, you will have a higher payment.  Another important consideration to keep in mind are the annual fees and termination costs.