Refinancing vs. a Home-Equity Loan: The Difference
If you’re already living in your home – and you have been for a few years – two financial terms probably keep popping up: refinancing and home-equity loans. Maybe you know a little about them but not enough to make financial decisions. They’re often used in the same sentence, but they’re drastically different. They do have one thing in common, though – they relate to raising money using your home.
Here’s a scenario: Ten years ago, when you first purchased your home, interest rates were nearly 6% on your 30-year fixed-rate mortgage. Now, in 2017, you could get a mortgage for around 4%. Two points could knock a couple of hundred dollars off your monthly payment and far more off the total cost of financing your home.
Or consider a second scenario: You already have an outstandingly low interest rate but you’re looking for some extra cash to pay for a new roof or add a deck to your home. That’s where a home-equity loan might become attractive. Over time, a combination of paying down your loan and your home appreciating in value produces equity—debt-free value in your home that you can borrow against to raise cash, and in tax-deductible ways, too.
Let's look at each of these options in detail.
Refinancing is basically finding a new lender to pay off your old mortgage balance in exchange for a new mortgage at a lower rate. Sometimes your current lender will do a refinance, too.
Two Types. There are two types of “refis” (mortgage lingo for refinance): the rate and term refinance and the cash-out loan. A rate/term refi doesn’t involve money changing hands other than the costs associated with closing. With a cash-out refi, you get some cash back – taking equity from your home in the form of cash. See Cash-Out vs. Rate/Term Mortgage Refinancing Loans for more information.
Consider the Costs. A lower interest rate that saves you hundreds per month must be a no-brainer, right? Very few financial decisions are cut and dried, and this is no exception. The problem is closing costs. Even on a refinance, these costs are likely to be 1% to 1.5% of your loan amount. If you refinance, you should plan to keep on living in your home for well over a year. In fact, if you can recoup your closing costs through a lower monthly payment within 18 months, it’s probably a good idea to do the refi. To read more, see: When (and When Not) to Refinance Your Mortgage.
Home-Equity Loans/Lines of Credit
Because they are secured by your property, home-equity loans tend to have lower interest rates than personal, unsecured loans. The only hitch: If you default on your home-equity loan, the lender comes after your home.
Two Choices. There are two types of home-equity loans. (Technically they’re quite different, but we’ll lump them together.)
A home equity line of credit (HELOC) is kind of like a credit card tied to the equity in your home. You can borrow as little or as much of that credit line, with an open-ended term, as you want. You may be required to pay a transaction fee each time you make a withdrawal, and an inactivity fee if you don't use your line of over a given period. During the draw period you pay only interest. Once the repayment period kicks in, you pay principal and interest.
In addition to disbursing the funds in disparate ways, interest works differently on these two instruments. The traditional home-equity loan has a fixed interest rate (though some may be adjustable) and the HELOC has a variable interest rate. The APR for a home-equity line of credit is calculated based on the loan's interest rate. The APR for a traditional home-equity loan generally includes the costs of initiating the loan.
Taking out a home-equity loan or a home-equity line of credit demands you submit various documents to prove you qualify, and imposes the same fees as a mortgage. These fees include closing costs such as attorney fees, title search and document preparation. They also often include an appraisal to determine the market value of the property, an application fee for processing the loan, points (one point is equal to 1% of the loan) and an annual maintenance fee. Sometimes, lenders will waive these, though; so do ask.
Can You Refinance These? In fact, you can. As with a traditional mortgage, if you can lower your interest rate, convert from an adjustable-rate loan to one with a fixed rate or avoid a balloon payment – or if you want to extract more cash from your equity – this might make sense for you. Just remember that every time you refinance something, you’re paying extra closing costs and you might be extending the loan, making your total interest payments higher. For more detail, see Refinancing Your Home-Equity Loan: A How-To Guide.
Comparing the Two. Both types of home equity-financing options are also referred to as “second mortgages” because they are secured by your property, just like the original (primary) mortgage. However, unlike the primary mortgage, these loans typically come with shorter repayment periods of anywhere from five to 15 years. Home-equity loans are ideal for borrowers who prefer the security offered by fixed-interest rates and for those requiring a substantial sum for a specific purpose, like another investment or debt consolidation (remember, it's a one-time loan – additional money cannot be withdrawn). HELOCs are suited to individuals who need access to a reserve of cash over a period of time, rather than upfront. You’re never paying interest on more borrowed funds than you actually use at any one time.
One Caveat: Your Credit Score
Your ability to borrow using either refinancing or home-equity loans depends on your credit score. If you’re looking to refinance, and your credit score is lower than when you originally purchased your home, refinancing may not be in your best interests. Before going through the process of securing either of these methods, get your three credit scores from the trio of credit bureaus. (See Top Places to Get a Free Credit Score or Report.) If they aren’t above 740, talk with any potential lender about how your score might affect your interest rate.
If you’re not planning to stay in your home for a long period of time, a home-equity loan, might be the better choice since the closing costs are less than those of a refi.
The Bottom Line
Refinancing and home equity loans have downsides, of course. If you’re refinancing, try not to take on another 30-year loan. Instead of putting the money you save into your pocket, opt for a shorter duration loan – maybe a 15-year mortgage. Or, take a 30-year loan and make extra payments. Remember that the payment isn’t as important as the total amount of money you pay over the life of the loan. Paying on your first loan for 10 years and refinancing for another 30 probably cancels out any positive effect of the refinance. The goal should always be to eliminate debt as quickly as possible.