Refinancing vs. Home Equity Loan: An Overview
Your home is not just a place to live, and it is also not just an investment. Your home can moreover be a handy source of ready cash to cover emergencies, repairs, or upgrades, obtained either through a mortgage refinancing or via a home equity loan.
Refinancing pays off your old mortgage in exchange for a new mortgage, ideally at a lower interest rate. A home equity loan gives you cash in exchange for the equity you've built up in your property as a separate loan.
- Refinancing and home equity loans both provide homeowners with a way to get cash based on the equity in the home.
- Refinancing can be ideal if you intend to stay in your home for at least a year and your interest rate will drop, resulting in lower monthly payments.
- Home equity loans are ideal for borrowers requiring a substantial sum for a specific purpose, such as a major home improvement.
- HELOCs are suited to individuals who need access to a reserve of cash over a period of time rather than upfront.
- A rate-and-term refi does not involve any money changing hands, other than costs associated with closing and funds from the new loan paying off the old loan.
- The cash-out refi effectively hands over some of the equity in your home as cash. You emerge from the closing with a new loan and a check for cash.
Closing costs are likely to be 2% to 3% of your loan amount, even on a refinance and you may be subject to taxes depending on where you live. You should plan to continue living in your home for a year or more if you take this route. It can be a good idea to do a rate-and-term refi if you can recoup your closing costs with a lower monthly interest rate within about 18 months.
If you’re not planning to stay in your home for a long period of time, refinancing might not be the best choice; a home equity loan might be a better choice because closing costs are less than with a refi.
Home Equity Loans
Home equity loans tend to have lower interest rates than personal, unsecured loans because they're collateralized by your property, and that's the catch: The lender can come after your home if you default.
Home equity loans also come in two flavors: the traditional home equity loan, in which you borrow a lump sum, and the home equity line of credit (HELOC).
A HELOC is like a credit card that's tied to the equity in your home. For a set time period after you receive it, known as the draw period, you can generally borrow as little or as much of that credit line as you want, although some loans do require an initial withdrawal of a set minimum amount.
You may be required to pay a transaction fee each time you make a withdrawal or an inactivity fee if you don't use your credit line at any time during a predetermined period. During the draw period, you pay only interest on what you've borrowed. When the draw period ends, so does your credit line. You start paying back the principal plus interest when the repayment period kicks in.
A traditional home equity loan is often referred to as a second mortgage. You have your primary mortgage, and now you're taking a second loan against the equity you've built in your property. The second loan is subordinate to the first—should you default, the second lender stands in line behind the first to collect any proceeds due to foreclosure.
Home equity loan interest rates are usually higher for this reason. The lender is taking a greater risk. HELOCs are sometimes referred to as second mortgages as well.
Home equity loans generally have a fixed interest rate, although some are adjustable, while HELOCs typically have adjustable interest rates. The annual percentage rate (APR) for a home equity line of credit is calculated based on the loan's interest rate, while the APR for a traditional home equity loan generally includes the costs of initiating the loan.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau and/or with the U.S. Department of Housing and Urban Development (HUD).
Example: Refinancing vs. Home Equity Loan
Let's say that 10 years ago, when you first purchased your home, interest rates were 5% on your 30-year fixed-rate mortgage. Now, in 2020, you can get a mortgage at an interest rate of 3.5%. Those one-and-a-half points can potentially knock hundreds of dollars a month off your payment, and even more off the total cost of financing your home over the term of the loan. A refinance would be to your advantage in this case.
Or, maybe you already have a low interest rate, but you’re looking for some extra cash to pay for a new roof, add a deck to your home, or pay for your child's college education. This is where a home equity loan might become attractive.
Your ability to borrow through either refinancing or a home equity loan depends on your credit score. If your score is lower than when you originally purchased your home, refinancing might not be in your best interest because this could quite possibly increase your interest rate. Get your three credit scores from the trio of major credit bureaus before going through the process of applying for either of these loans. Talk with potential lenders about how your score might affect your interest rate if they're not all consistently over 740.
Taking out a home equity loan or a home equity line of credit demands that you submit various documents to prove that you qualify, and either loan can impose many of the same closing costs as a mortgage. These include attorney fees, a 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, however, so be sure to ask.
The Bottom Line
Refis and home equity loans can benefit homeowners who want to turn the equity in their home into cash. To decide which is the best move for you, consider how much equity you have available, what you will be using the money for, and how long you plan to stay in your home.