Home Equity Loan vs Refinance–What’s the Difference?

The equity that you have in your home can be a useful tool to help you accomplish other financial goals you have like paying off expensive debt, paying for college tuition, or making renovations to your home. There are several ways to turn your equity into liquid cash, including home equity loans and cash-out refinances.

If you’re considering taking out a home equity loan or a cash-out refinance, understanding the difference between the two can help you make an informed decision.

What is a home equity loan?

A home equity loan is money borrowed against the equity you have in your house. Because home equity is used as collateral to secure the loan, the lender assumes less risk, which translates to favorable interest rates and loan terms for borrowers.

A home equity loan is considered a second loan, meaning that it doesn’t replace your existing mortgage. When you take out a home equity loan, you’ll still need to make your original mortgage payments each month, along with the monthly payment for your new loan.

What is a home refinance?

There are two main types of home refinancing: rate-and-term refinancing and cash-out refinancing.

With a rate-and-term refinance, you will pay off your existing mortgage with a new one in the same amount that has different terms like a lower interest rate or shorter payment period.

On the other hand, if you opt for a cash-out refinance, you’ll take out a loan that’s bigger than your current mortgage. You’ll pay off the existing mortgage and pocket the difference for personal use.

For example, if you still owe $50,000 on your home, you could get a cash-out refinance for $70,000 (provided you have enough equity in your home, but we’ll talk about that later). The first $50,000 of the new mortgage will pay off your old one and you’ll get to keep the remaining $20,000 for whatever you want.

Cash-out Refinance vs. Home Equity Loan: How They Compare

So how do they stack up against each other? Here are some similarities and differences between the two.

How They’re Alike

In many ways, a cash-out refinance and a home equity loan are the same. With both options:

• You can use the money however you see fit. Many people use their money to cover home renovations, college tuition and fees, medical bills, or to consolidate debt. And while there might be wiser ways to use your loan, nothing is stopping you from funding a luxury vacation with your money.
• The money will come in a lump sum. Unlike a home equity line of credit, the money from a home equity loan or cash-out refinance will be given to you all at once.
• You’re limited by the equity that you have in your home. One option won’t give you more money than the other since both involve borrowing against the equity in your home.
• You are bound by the same home equity laws. Texas has some special laws regarding home equity that apply to both home equity and cash-out refinances.

How They’re Different

There are a few key differences between the two that you’ll want to keep in mind.

• A home equity loan is a second loan; a cash-out refinance replaces your first mortgage. If you had a home equity loan and defaulted on your house, and the bank foreclosed and sold it, the first mortgage lender would recoup their losses before the second loan lender. If you had a cash-out refinance, there would only be one lender involved.
• Cash-out refinances typically have better interest rates.
• Repayment terms may be different. Cash-out refinances are available in 15-year or 30-year terms. Home equity loans are offered in a greater variety of term lengths, ranging from 5 years to 30 years. At the same interest rate, the shorter the loan term is, the less interest you’ll pay overall since it has less time to compound.
• Closing costs are usually lower for home equity loans. Texas law caps cash-out refi closing costs at 2% of the total loan amount, however some financial institutions offer home equity loans for an even lower flat rate.

Texas Laws Regarding Home Equity Loans and Cash-out Refinances

Texas has some unique laws when it comes to using the equity in your home, and it’s important to fully understand how they impact you, your home, and your plans for the future.

1. You cannot use more than 80% of your home’s equity.

If you’re taking out a home equity loan, you cannot tap into more than 80% of your home’s equity— even if you don’t owe anything. So, for instance, if you have a home that is worth $200,000, and you have 100% equity in the home, the largest home equity loan that you could obtain would be $160,000.

If you also owe money on the home, you will have to factor that in. So if you still owed $60,000 on your mortgage, the maximum that you could take out would be a $100,000 loan. What you owe on your mortgage and what you owe on your home equity loan can be no more than 80% of the home’s value.

The same is true for a cash-out refinance. If you have 50% equity in your $200,000 home and wanted to do a cash-out refinance, the maximum loan amount that you could get would be $160,000— $100,000 would go towards paying off your current mortgage and $60,000 would be given to you as cash.

This means that in order to take out a home equity loan or a cash-out refinance, you need to have at least 20% equity built in your home.

2. You can only have one outstanding equity loan.

Texas law permits that you can only have one home equity loan or one cash-out refinance loan at a time.

3. You can only take out one equity loan every 12 months.

Even if you repay your first home equity loan or cash-out refinance, you are still only permitted to tap into your equity once per year. This is important to keep in mind if you think you might need another loan a few months down the road.

Tap into Your Equity to Meet your Goals

Both home equity loans and cash-out refinances can be used to help you meet your financial goals. By using your home’s equity as collateral, both options can put some cash in your pocket at a lower cost than other forms of financing. But as with any form of financing, it’s important to first do your research beforehand and understand the risk involved with taking on more debt.