When you need a large sum of money in a hurry, you have two options. You can either take a personal loan or refinance your home mortgage to cash out equity.
If you have an emergency fund, it’s best to use that for times when you need money overnight for say, urgent medical expenses or car repairs. Don’t use this money to support a business venture, pay wedding expenses, or fund a home-improvement project. For these expenses, it’s best to either take a personal loan or free up money with a cash-out refinance.
When it comes to personal loans or refinance, neither one is better than the other for everyone. Which one is best for you will depend on a variety of factors. Understanding the differences between the two will help you decide which one to use to get the funds you need.
How A Personal Loan Works
Personal loans are offered by banks, credit unions, and private lenders. Most financial entities will approve your personal loan application based on your credit score, income, and debt-to-income ratio. Some lenders may also require you to put up some collateral to secure the loan. The personal loan approval process is quick. You can expect to get the funds in a couple of days if you qualify.
To repay the loan, you will have to pay a fixed amount every month for the set term of the loan. There are no restrictions as to how you can use these funds. Personal loan funds can be used for just about any purpose.
How A Cash-Out Mortgage Refinance Works
A cash-out mortgage refinance involves using your property as collateral to take out a new home loan. In this case, you take a loan that’s large enough to pay off your existing mortgage plus the cash amount you need.
The most important thing to keep in mind is that you must have “˜tappable’ equity to qualify for a cash-out mortgage refinance. Tappable equity is the equity you can borrow against.
For example, if your property is worth $300,000 but you only owe $100,000 on your mortgage, your home has $200,000 of equity. You cannot borrow against the full equity amount. Lenders will typically require that you keep the loan-to-value ratio below 85%. If you don’t have tappable equity, a cash-out mortgage refinance will not be an option for you.
If you have tappable equity and qualify, to repay the loan, you will have to pay a fixed amount every month till the debt is cleared. There are no restrictions on how you can spend the funds received from a cash-out mortgage refinance.
[table “2” could not be loaded /]Comparing Personal Loans And Cash-Out Mortgage Refinance
You’ve seen how a personal loan and a cash-out mortgage refinance works. Here’s a more detailed look into how the two types of loans compare against each other in various respects.
Interest Rates
In general, interest rates on personal loans are higher because there’s no collateral involved. Lenders quote higher rates on personal loans to offset the risk of offering you an unsecured loan. With a cash-out refinance, the loan is secured by your property, so the lender doesn’t need to worry about the risk factor.
However, not all borrowers pay the same interest rates on either type of loan. Whether you’re taking a personal loan or refinancing your mortgage, your interest rate will depend on a few criteria. These may include your credit score, income, debt-to-income ratio, employment, and other factors including the loan amount. You may qualify for a low interest rate on your personal loan, if your credit score is high. Still, the low interest rate on a personal loan often tends to be higher than the lowest rate on a home equity loan.
Upshot: Compare interest rates with both options before making a decision. Also check your home equity. If you don’t have strong credit but can tap your home equity, you may be able to save a substantial amount of money by choosing a cash-out mortgage refinance over a personal loan.
Collateral and Home Equity
Most lenders will approve your personal loan application without collateral, provided that you meet their minimum requirements. Moreover, there are no limits as to how much you can borrow, as long as you met the borrowing criteria.
To get approved for a cash-out refinance loan, you must have a certain amount of equity in your home. Lenders usually require homeowners to keep at least 20% equity. This limits your new loan amount to 80% of your home’s appraised value.
Upshot: You don’t have to worry about collateral or borrowing limits with a personal loan. With a cash-out mortgage refinance, you’re essentially putting up your home as collateral and you’re limited about the amount of equity you have in your home. Choose a personal loan if your home equity is limited or you don’t want to put your home at risk. Choose a cash-out refinance mortgage if you have sufficient equity in your home and the borrowing limit meets your needs.
Processing Time
With a personal loan, you can expect to receive the funds in a couple of days, as long as you meet the lender’s minimum criteria and provide the necessary documents. The lender will take a day or two to check your credentials. If everything is in order, you’ll get approved and the funds will be disbursed immediately.
A cash-out mortgage refinance takes much longer. The approval process can be hugely time-consuming, involving an appraisal, underwriting, and other formalities. The process of closing a home equity loan and disbursing the funds can take a couple of weeks or even longer.
Upshot: A personal loan is a better option if you need the funds immediately. If you don’t need the funds urgently, weigh all other factors before deciding between the two.
Loan Fees
Fees can vary considerably not just between personal loans and mortgage refinance but also among lenders. Every lender sets their own fees for each of these processes.
You can expect to pay anywhere from 0% to 5% of the loan amount as fees for processing a personal loan. These are just the lender’s fees. There are no other fees involved in processing personal loans.
With a cash-out mortgage refinance, you can expect to pay anywhere from .25% to 3% of the loan amount. Only part of these fees are the lender’s fees. The other costs go towards 3rd party services such as appraisal, escrow, and title insurance fees.
Upshot: Make sure to calculate and compare how much a personal loan will cost you compared to the cost of a cash-out mortgage refinance.
Repayment Period
Personal loans generally have shorter repayment periods of about 1 to 5 years. Very few lenders offer more and may go up to 7 years. Very rarely will any lender offer repayment periods of more than 7 years.
Mortgage refinance repayment terms are longer, with most common terms being 15, 20, and 30 years. Few lenders offer 10-year repayment terms.
Upshot: If you need to borrow a small amount and would prefer to pay it back faster, it’s better to take a personal loan. Consider a cash-out mortgage refinance only if you need to fund a large, expensive project and only if it is really worth using your home as collateral for.
Tax Benefits
Personal loans don’t offer any tax benefits. With a mortgage refinance, if you use the funds for home improvements that boosted the value of the property, you may be able to deduct the interest on the loan from your taxes.
Upshot: This is not really a major factor to consider when choose between personal loans and mortgage refinance. But it can be a nice little bonus if you decide to choose a mortgage refinance over a personal loan.
Should You Take A Personal Loan Or Refinance Your Mortgage?
Neither personal loans nor cash-out mortgage refinance are the best financing option for everyone. The best option for you will depend on a variety of factors.
Choose a personal loan if:
- You need the funds immediately
- You don’t need to borrow a lot of money
- You prefer to pay the loan back quickly and get out of debt faster
- You don’t have tappable equity in your home (without tappable equity, you won’t qualify for cash-out mortgage refinance)
Choose cash-out mortgage refinance if:
- You have tappable equity in your home
- You need to borrow a substantial sum
- You’re not in a hurry to get the funds and can wait a few weeks
Whether you’re looking to take a personal loan or refinance your mortgage, make sure to compare lenders and their terms, fees, and interest rates before signing any loan agreement. The time spent in researching lenders is well worth it when you consider it could save you a tidy sum in fees and accrued interest.
