Should You Use a Cash-Out Refinance or a Home Equity Loan?

When you’ve built up equity in your house, you might start thinking about using that money for something big—like paying off credit cards, fixing the roof, or putting a down payment on a second home. One common way to get that cash is a cash-out refinance. But it’s not the only option. Another popular choice is a home equity loan. Understanding the difference between the two can help you decide which one fits your situation better.

Let’s start with a cash-out refinance. This means you take out a brand new mortgage that replaces your current one. The new loan is bigger than what you still owe on your house. You get the extra money as a lump sum of cash. For example, say your house is worth three hundred thousand dollars, and you owe one hundred and fifty thousand. You might refinance for two hundred thousand, which pays off the old mortgage and gives you fifty thousand dollars in your pocket. Your monthly payment will change because the interest rate and loan term might be different. Most of the time, you’ll end up with a new rate that could be lower or higher than what you had before.

One big advantage of a cash-out refinance is that you get one single loan payment. You don’t have a separate second mortgage to worry about. Also, the interest rate on a first mortgage is usually lower than the rate on a second loan like a home equity loan. That can save you money over time. But there are downsides. You’re resetting your mortgage term. If you were ten years into a thirty-year loan and you refinance into another thirty-year loan, you’ll be paying interest for longer. Closing costs can also be significant—expect to pay anywhere from two to five percent of the loan amount. And because you’re taking out more debt, you’re increasing your monthly payment unless you get a much lower rate or a longer term.

Now let’s look at a home equity loan. This is a completely separate loan that sits behind your first mortgage. It’s sometimes called a second mortgage. You borrow a fixed amount against the equity in your house, and you get that money as a lump sum. Then you pay it back over a set number of years, usually with a fixed interest rate. Your monthly payment for this loan is separate from your existing mortgage payment. So you’ll have two payments to make each month.

A home equity loan can be a good alternative when you don’t want to mess with the terms of your first mortgage. Maybe you already have a great low rate and you don’t want to lose it. A cash-out refinance would replace that low rate with whatever today’s rates are. But a home equity loan leaves your first mortgage untouched. Also, closing costs on a home equity loan are often lower than on a cash-out refinance. Some lenders even offer no-closing-cost options, though that usually means a higher interest rate.

On the other hand, a home equity loan usually has a higher interest rate than a first mortgage because it’s riskier for the lender. If you default, the first mortgage gets paid first. You’ll also have two monthly payments, which means two bills to keep track of. And if you ever want to refinance your first mortgage later, having a second loan can complicate things.

So which one should you pick? It really depends on your goals and your current mortgage situation. If your existing mortgage has a high interest rate, a cash-out refinance might let you lower that rate while also getting cash. That could be a win-win. But if your current mortgage rate is low and you don’t want to give it up, a home equity loan is probably the better route.

Another thing to think about is how much cash you need. If you only need a small amount, the closing costs on a cash-out refinance might not be worth it. Home equity loans sometimes have lower costs for smaller loan amounts. But if you need a lot of cash, a cash-out refinance could make sense because you’re only paying closing costs on one loan.

Also consider your long-term plans. If you plan to move in a few years, the upfront costs of either option might not pay off. In that case, you might look into a home equity line of credit (HELOC) instead, which works like a credit card and only charges interest on what you use. But that’s a different topic.

Before you decide, shop around. Get quotes from at least three or four lenders for both types of loans. Compare the interest rates, closing costs, monthly payments, and how long you plan to stay in the house. Run the numbers. Sometimes the choice is clear. Other times, it’s a toss-up.

Remember, using your home equity means you’re putting your house on the line. If you can’t make the payments, you could lose your home. So only borrow what you truly need and have a solid plan to pay it back. Both a cash-out refinance and a home equity loan can be useful tools, but they’re not free money. Use them wisely, and you can improve your financial situation without unnecessary risk.