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Personal Loan, Home Equity Loan or Cash Out Refinance? Which Is Cheaper?

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Modern home in the snowIf you need money for home improvement, debt consolidation or other big-ticket expenses, what is better: a personal loan or a cash-out refinance?

Learn the pros and cons of personal loans, home equity loans and cash out mortgage refinancing so you can make the right decision.

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What Is a Personal Loan?

A personal loan is almost always unsecured financing. This means that, unlike a mortgage, there is no collateral that the lender can take if you don't repay the loan. This is the main characteristic of personal loans. There are other traits of personal loans that stem from the fact that they are unsecured by property:

  • Personal loans are riskier to lenders and so they have higher interest rates than mortgages or auto loans.
  • Applications can be processed much more quickly because there is no property to appraise.
  • Personal loan interest rates are mostly dependent on the applicant's credit score.
  • These loans have low or no set-up costs.
  • Personal loans are private transactions. The lender does not record a lien with your local government.

Other personal loan traits include shorter terms than most mortgages - usually between one and five years but can be as long as 12 years for higher loan amounts. Personal loans nearly always come with fixed interest rates. Interest rates for personal loans run from about 6% to about 36%. That is a much wider variation than you'll see with mortgages.

What Is a Cash Out Refinance?

A cash out refinance is a mortgage transaction. The homeowner replaces an existing mortgage with a new, larger mortgage, and takes the difference between the two as cash at closing. The borrower can use the money for any legal purpose.

  • Because the borrower's home is security for the loan, there is less risk to the lender, and interest rates are lower.
  • Most lenders require a home appraisal and title insurance.
  • Cash out refinances can have fixed or adjustable interest rates.
  • Mortgage refinance rates vary much less than unsecured loan rates.
  • Mortgage transactions are public. The lender files a lien with your county recorder's office.

Cash out refinances cost more than ordinary rate-and-term refinances. Lenders add surcharges because a cash out feature does make a mortgage riskier. This surcharge is usually a percentage added to the entire loan amount, not just the cash out portion. This is an important distinction, as you will soon see.

What Is a Home Equity Loan?

A home equity loan is a mortgage secured by your home.

  • It can be a fixed-rate installment loan or a variable-rate line of credit called a HELOC.
  • These loans are often called "second mortgages."
  • Home equity loans are riskier to mortgage lenders than first mortgages, and so their interest rates are higher. But, because they are backed by real estate, their interest rates are lower than those of unsecured personal loans.
  • Home equity loans generally come with terms up to 20 years, with 10-15 years being common. Interest rates vary more than those of first mortgages, but less than those of personal loans.

Fixed home equity loans come with most of the same closing costs that first mortgages have, including lender fees, title charges and home appraisal costs. HELOC set-up charges are often much less.

When Is a Personal Loan the Best Choice?

There are several circumstances that make personal loans the best financing choice.

  • The personal loan is the right choice when you don't have enough home equity to cash out. If your mortgage plus the amount of cash you want exceeds 80% of your home's value, a cash out refinance will be difficult and expensive to obtain. If your current mortgage plus the amount of cash you want exceeds 90% of your property value, you'll have difficulty finding a home equity loan or HELOC.
  • Personal loans are also a better choice when the amount you need is relatively small. That is because the cost of setting up a personal loan is much lower than the title, appraisal and lender fees you'll pay with most mortgage products. And for applicants with the best credit scores, personal loan interest rates approach those of home equity financing.
  • Personal loans can be the right choice when speed is important. If you need to make an investment quickly, for instance, you might get your money in a day to a week with a personal loan. Typical closing times for home loans are 30 to 45 days.

Finally, personal loans are perfect when you don't want your borrowing to be public knowledge. You can transact your business privately when it does not involve real estate.

When Is a Cash-Out Refinance the Right Decision?

A cash-out refinance is the right move when all of these conditions are true:

  • You can refinance to a better interest rate than you currently have.
  • You'll recoup the cost of refinancing before you sell or refinance your home.
  • The cash-out refinance costs less than a rate-and-term refinance combined with a personal loan or home equity loan.

You can probably see that the instances in which a cash out refinance is the best option are fairly limited. It only makes sense when the amount of cash you want is large compared to your mortgage balance.

When Is a Home Equity Loan Right for You?

Home equity loans are a great option:

  • When you need a smaller loan amount and you have enough home equity to support a loan against your property and the costs (including set-up and interest) are lower than those of a personal loan.
  • For borrowers with imperfect credit, the difference between personal loan interest rates and home equity loan rates is more pronounced.

You should always compare home equity and personal loans before making a financing decision.

How to Run the Numbers

You can compare the cost of financing with the following steps:

  • Determine the loan's set up costs. That is every fee paid to the lender or third parties that is not interest.
  • Calculate the loan payment, including principal and interest.
  • Multiply that payment by the number of months in your loan term.
  • Subtract the amount you're borrowing from that total. What's left is your total borrowing costs.

Regardless of which loan you select, you'll always save by choosing the shortest term that you can afford. Extending repayment to longer terms decreases your payment but increases your total borrowing costs. There is nothing wrong with this if it is your goal and you understand what it adds to your total expense.

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