Traditional mortgage refinance vs. cash-out refinance: Which is better?

Despite some encouraging signs in the economy, inflation continues to persist. The Federal Reserve is widely expected to raise rates again at its next meeting in late July, likely causing mortgage rates to tick up again. Earlier this month, according to Freddie Mac, mortgage rates reached their highest point since November 2022, with a 6.96% average interest rate on a 30-year fixed-rate mortgage.

These higher mortgage rates are impacting the real estate market, leaving both buyers and sellers with fewer options. As such, many are considering their refinancing options. With a traditional mortgage refinance, you may be able to lock in new terms that make your home more affordable. By contrast, a cash-out refinance could provide you with the necessary cash to make home improvements or buy another property.

Understanding how traditional and cash-out refinances work can help you determine if a refinance could move you closer to your financial goals. Get a personalized refinance rate here now and learn more.

Traditional mortgage refinance vs. cash-out refinance

Before trying to determine which mortgage refinancing option is best for you it's helpful to first understand how each type works.

What is a traditional mortgage refinance?

A traditional mortgage, also known as a rate-and-term refinance, allows you to obtain a new mortgage, ideally with more favorable terms. The new loan pays off your original loan, so your principal balance is unchanged. However, you could have a new mortgage rate and loan term.

For example, let's say you have 25 years remaining on a $300,000 variable-rate mortgage at 6.5% interest and monthly payments of $2,025. By opting for a rate-and-term refinance with a new 15-year mortgage at a fixed 5% mortgage rate, you could shave 10 years off of your loan. You'd also make your loan payment more manageable by avoiding the inevitable rate hikes that come with variable-rate mortgages. And while your new monthly payment would be higher at $2,372, you'd save over $180,000 in total interest paid over the life of your loan.

Learn more about traditional mortgage refinancing here now.

What is a cash-out refinance?

As its name suggests, a cash-out refinance allows you to tap into the equity you've built up in your property and access it as cash by taking out a larger mortgage. A cash-out refinance is similar to a traditional one in that it replaces your current mortgage with a new one—and likely with a new rate and term. However, this type of refinance is unique because the new loan will be larger than your current one and you can pocket the difference in cash. You can use your cash-out funds to pay off high-interest credit cards, fund a home renovation project or virtually any other purpose.

Generally, you must have at least 20% equity in your home to qualify for a cash-out refinance, and mortgage refinance companies may allow you to access up to 80% of your home's equity.

When a traditional mortgage refinance may be better

A traditional mortgage refinance is an option to consider if you want to lower your monthly mortgage payment by extending your loan term, although you'd pay more interest over the life of the loan. Conversely, you could shave years off your mortgage by refinancing from a 30-year mortgage to a 15-year mortgage, potentially saving you thousands of dollars over your loan's term.

"A traditional refinance makes sense for homeowners when the new available interest rate is low enough—at least 50 basis points lower—for the savings to outweigh the costs," says Afifa Saburi, senior researcher at Veterans United Home Loans. "A homeowner should also consider how long they plan to live in the home and how much money they will save each month."

Find out what mortgage refinance rate you qualify for here now.

When a cash-out refinance may be better

Because you're taking on more debt with a cash-out refinance, many experts recommend only obtaining this type of mortgage refinance for a serious need, such as a large unexpected medical bill or a long-term investment like college tuition. Of course, you'll want to shop and compare your other options, too.

Many homeowners use the funds from a cash-out refinance to consolidate high-interest debt or make home improvements. In some cases, you can deduct the interest on your refinance on your tax return, but only if you use the money to make home improvements that improve your home's value. Before taking out a cash-out refinance, it's wise to consult your tax accountant to see if you would qualify for a tax deduction.

It's also smart to keep an eye on lender charges when considering a cash-out refinance. "Lenders typically view cash-outs as higher risk, resulting in premium charges," says Kurt Carlton, co-founder and president of New Western. "If cash is not needed, this type of refinance is not recommended."

The bottom line

Traditional and cash-out refinances have unique features which can benefit you in various ways, whether you simply want to change the terms of your loan or if you want to access your equity to help you achieve important financial objectives. Before proceeding, consider the pros and cons of refinancing and other financing options, such as a home equity loan or home equity line of credit.