Real estate investors often face the challenge of choosing the best financing options to not only maximize their investment returns but to also grow their portfolio. Unlocking home equity with a rental property refinance can help you do just that.
With U.S. home prices seeing the highest growth rate in at least 31 years – 18.7% between 2021 to 2022 to be exact – you may have even more equity in your rental property than you originally thought. Two popular ways to tap into home equity are cash-out refinances and home equity loans, each with different features and benefits.
In this guide, we’ll be exploring the differences between these financial strategies to help you determine which option is best for your goals. Keep reading to learn more!
Understanding Home Equity Loans and Cash-Out Refinances
Although home equity loans and cash-out refinances give investors a way to unlock equity in their rental properties, they’re quite different in how they’re structured. In this section, we’ll be covering how these financing options work and what’s required to qualify for each of them.
How Does a Home Equity Loan Work?
A home equity loan is a type of loan that allows homeowners to borrow money against the equity they have built up in their property. With a home equity loan, you receive a lump sum of money and repay it with fixed monthly payments over a set term. The homeowner borrows this amount against the equity built up in their property. Since a home equity loan is separate from your original mortgage, the home equity loan lender has a second lien on the property. The interest rate on a home equity loan is typically fixed, which makes the repayments predictable. You can get a home equity loan on a primary, secondary or investment property.
What Are the Requirements for a Home Equity Loan?
Exact requirements for a home equity loan depend on the lender. Generally, lenders typically require the following:
- Sufficient Equity: You generally need at least 20-30% equity in your home, but this can vary by lender.
- Good Credit: A strong credit score is essential. Aim for a credit score of 620 or higher.
- Low Debt-to-Income Ratio: Lenders prefer borrowers with a low debt-to-income (DTI) ratio, which indicates that you can manage monthly payments. Aim for a DTI of 43% or lower.
- Proof of Income: You’ll need to provide documentation of your income to verify your ability to repay the loan.
- Homeowners Insurance: Having homeowners insurance is typically a requirement.
How Does a Cash-Out Refinance Work?
A cash-out refinance involves replacing your existing mortgage with a new one for a larger amount – a valuable tool that gives homeowners a chance to access cash while potentially securing better loan terms or interest rates. The difference between the new loan and the old loan is given to you as cash. Basically, you’re borrowing more than you owe on your current mortgage and using the extra cash for whatever you need. Keep in mind that a cash-out refinance may result in a higher monthly mortgage payment due to the larger loan amount.
What Are the Requirements for a Cash-Out Refinance?
Similarly to the home equity loan requirements, the specific requirements for a cash-out refinance depend on the lender and the loan type you choose. However, these are the requirements lenders typically need:
- Sufficient Equity: You’ll need a certain amount of equity in your home, usually at least 20-30%, but this can vary.
- Good Credit: A strong credit score is essential and it’s recommended to have a credit score of 620 or higher.
- Low Debt-to-Income Ratio: Lenders prefer borrowers with a low debt-to-income (DTI) ratio and you should aim to have a DTI of 43% or lower.
- Home Appraisal: Your home will need to be appraised to determine its current market value.
- Proof of Income: You’ll need to provide documentation of your income to verify your ability to repay the loan.
Key Differences and Similarities
Now that you know how both cash-out refinances and home equity loans work, let’s dive into their key differences, similarities, and pros and cons to further compare them.
Similarities Between Home Equity Loans and Cash-Out Refinances
Home equity loans and cash-out refinances share a few key similarities. Both financial tools allow you to access the built-up equity in your home for different purposes like home improvements, debt consolidation, or investing in additional properties.
With both options, the loan amount is based on the difference between your home’s current market value and the outstanding mortgage balance, typically allowing you to unlock up to 80% of the property’s value. Additionally, both options use your home as collateral, meaning potentially lower interest rates compared to unsecured loans like personal loans or credit cards. Lastly, the interest you pay on home equity loans and cash-out refinances may be tax-deductible depending on your situation. While the structure and repayment terms may differ, both home equity loans and cash-out refinances give investors the chance to convert their home equity into cash.
Differences Between Home Equity Loans and Cash-Out Refinances
Despite having several similarities, home equity loans and cash-out refinances also have some key differences as well. We’ve outlined these differences below:
- Loan Structure: A home equity loan is a second mortgage that’s separate from the original mortgage, whereas a cash-out refinance replaces your existing mortgage with a new, larger one.
- Equity Access: A cash-out refinance may unlock more funds than a home equity loan, making it better suited for purposes where more cash is needed.
- Repayment: A cash-out refinance streamlines your repayment with one monthly payment, whereas a home equity loan has a separate monthly payment from your original mortgage.
- Loan Term: Home equity loans typically have shorter repayment terms than a cash-out refinance. Since a cash-out refinance is essentially a new mortgage, it “resets” the mortgage clock, leading to a full mortgage term.
- Interest Rates: Rates for cash-out refinances are generally lower than those on home equity loans.
Keep in mind that neither loan option is necessarily better than the other. If you’re trying to decide between the two, it’s important to factor in all of these considerations to see which one is a better fit.
Pros and Cons of Home Equity Loans
Pros:
- Opportunity to unlock equity you’ve built in your rental property
- Fixed interest rate provides predictable monthly payments
- Receive the entire loan amount as a lump sum
- Lower interest rates compared to credit cards or personal loans
- Interest may be tax deductible depending on your situation
Cons:
- Potential to be over-leveraged
- Risk of foreclosure if you default on the loan
- Significant equity in your home is required to qualify
Pros and Cons of Cash-Out Refinance
Pros:
- Allows you to tap into your home equity and turn it into cash
- Only one monthly payment for the new, larger mortgage
- Receive the proceeds as a lump sum
- Typically lower interest rates compared to unsecured loans and home equity loans
- Interest is potentially tax deductible depending on your situation
Cons:
- Potential to over-leverage yourself
- Foreclosure risk if you fail to make loan payments
- Significant equity in your home is required to qualify
Which Option Should I Choose?
Lastly, let’s explore certain scenarios where a home equity loan or a cash-out refinance would be a better option. Remember, there’s no right or wrong answer when it comes to choosing one – they’re both valuable financial tools that can benefit different people.
Best Situations for Home Equity Loans
As a real estate investor, there are some situations where a home equity loan might make more sense than a cash-out refinance, including:
- Maintaining a Low Existing Mortgage Rate: If your current mortgage has a significantly lower interest rate than what’s available for new loans, a home equity loan allows you to tap into your home equity without changing your mortgage.
- Specific, Large Expenses: A home equity loan could be a great option to finance a clear, specific purpose like renovations or purchasing another investment property.
- Shorter Loan Term: Home equity loans come with shorter repayment terms compared to cash-out refinances, which can be a benefit if you want to pay off the loan more quickly.
- Keeping Your Debts Separate: If you prefer to keep your debts separate, a home equity loan allows you to access the cash without having to consolidate your debts.
Best Situations for Cash-Out Refinances
While home equity loans have their advantages, there are certain scenarios where a cash-out refinance may be more beneficial, including:
- Lowering Your Mortgage Rate: If current mortgage rates are lower than the rate on your current mortgage, a cash-out refinance can help you secure a lower rate while unlocking your home equity.
- Accessing More Cash: A cash-out refinance typically allows you to borrow more money than a home equity loan.
- Streamlining Your Finances: Consolidating your existing mortgage and the new loan into a single monthly payment simplifies your finances.
- Extending Your Loan Term: A cash-out refinance resets your mortgage term, which can help to lower your monthly payments and improve cash flow.
- Debt Consolidation: Paying off high-interest debts, such as credit cards or personal loans, to lower overall interest rates and simplify payments.
Cash-Out Refinance vs. Home Equity Loans for Real Estate Investors FAQs:
- What is a cash-out refinance?
A cash-out refinance is a financial tool that replaces an existing mortgage with a new loan that has a higher loan amount, which allows the borrower to cash out the difference.
- What is a home equity loan?
A home equity loan is a second mortgage taken out against the equity in a property. It provides a lump sum of cash that is repaid over a fixed term with a fixed interest rate.
- Which option provides more cash access: cash-out refinance or home equity loan?
Cash-out refinances typically allow for higher loan amounts because they replace the existing mortgage, which allows you to borrow up to 80% of your home’s value. On the other hand, home equity loans are limited to your home’s value minus the balance on your mortgage.
- Is a cash-out refinance or a home equity loan a better option for real estate investors?
Deciding between a cash-out refinance or a home equity loan depends on your goals. A cash-out refinance may be a better option if you need a larger amount of cash and want to simplify your debts into one monthly payment. A home equity loan may be a good option if you need a smaller amount of cash and are able to keep up with an additional loan payment.
- What are the interest rates like for cash-out refinances vs. home equity loans?
Interest rates for cash-out refinances are often lower than those for home equity loans, as they are considered first mortgages. Home equity loans usually have higher rates because they are second mortgages, meaning that in the event of a foreclosure, the lender would not see any money until the first mortgage is paid off.
- Which option has lower closing costs?
Generally, home equity loans have lower closing costs compared to cash-out refinances.
- Which option is better for long-term investment goals?
For long-term investment goals, a cash-out refinance may be a better choice because of potentially lower interest rates, which reduces the overall total loan cost. However, it’s important to consider the loan term since a cash-out refinance replaces your existing mortgage with a new one.
- Does Defy Mortgage offer cash-out refinances for real estate investors?
Yes! Defy Mortgage offers cash-out refinances for real estate investors. We specialize in non-QM loan options, which provide investors with flexible and customizable loan solutions for your cash-out refinance.
- Does Defy Mortgage offer home equity loans for real estate investors?
Yes! Defy Mortgage offers home equity loans for real estate investors. Contact us today for a free consultation – we’d be happy to help you pick the right option for you!
