Your home is kind of like a giant piggy bank, and the amount in it at any given point is the difference between its market value and what you currently owe on your mortgage. If you're interested in tapping into the money in the piggy bank, you have two major options. You can either refinance your entire mortgage for an amount higher than what you currently owe, which is called a cash-out refinance, or you can take out a home equity loan, which is sometimes called a second mortgage.
Distinctive Features of Cash-Out Refinance
You've probably heard of a refinance before, and a cash-out refinance is the same thing, but you borrow extra so you'll walk away with cash at closing. A cash-out refinance entirely replaces your existing mortgage with a new mortgage. You'll get the new mortgage at today's interest rates, which may be an improvement over the rate you originally got on your mortgage. The additional money you borrow is part of your mortgage, and you make just one monthly payment. However, you have to pay all of the closing costs associated with a refinance, which often amount to 3 percent to 6 percent of your mortgage amount.
Distinctive Features of Home Equity Loan
A home equity loan is an additional loan on top of your current mortgage. You will keep your current mortgage and its payments, and you'll be adding another loan and making monthly payments on that as well. You can choose how long you want the repayment term to be on your home equity loan, and can choose to have it end before you finish paying off your mortgage to reduce payment stress later in life. Home equity loans usually have higher interest rates than mortgages because they are riskier for lenders. However, they also have lower closing costs.
When Refinancing is Better
A cash-out refinance is usually the best choice if you can refinance at a significantly lower interest rate than you're paying on your existing mortgage. It's also a good option if you can't afford to make the additional monthly payments that would be required on a home equity loan. Especially if you have had your mortgage several years already, adding to its balance and extending the repayment term back out to 30 years should not affect your monthly payments much.
When a Home Equity Loan is Better
If you already have a great interest rate on your mortgage, a home equity loan is probably the best choice. In addition, if you're not planning to borrow much, it doesn't make sense to refinance and pay the high closing costs, which could add up to nearly the amount you're borrowing. Another factor that can affect the decision is how long you plan to stay in the home. If you'll be selling in a year or two anyway, it would be better to take the home equity loan with the lower closing costs because you won't be paying the higher interest rates for very long.