Refinancing vs. Home Equity Loan: An Overview

Your home is not just a place to live, and it's not just an investment. It also can be a source of ready cash should you need it through refinancing or 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.

Refinancing

There are two types of “refis”: a rate and term refinance, and a cash-out loan. A rate/term refi doesn’t involve any money changing hands, other than costs associated with closing and funds from the new loan paying off the old loan. You can take money out with a cash-out refi, as you're effectively turning the equity in your home into cash.

Closing costs are likely to be 1 percent to 1.5 percent of your loan amount, even on a refinance. 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 this type of rate/term refi if you can recoup your closing costs with a lower monthly interest rate within about 18 months.

Home Equity Loans

Home equity loans tend to have lower interest rates than personal, unsecured loans because they're secured by your property, but there's a catch with that. The lender can come after your home if you default on a home equity loan or line of credit.

A home equity line of credit (HELOC) is like a credit card that's tied to the equity in your home. 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 amount. You might 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. You only pay interest during the draw period, then you'll pay 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. 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.

Refinancing vs. Home Equity Loan Example

Ten years ago, interest rates were just above six percent on your 30-year fixed-rate mortgage when you first purchased your home. Now, in 2019, you can get a mortgage at an interest rate of about four percent. Those two 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.

Special Considerations

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 one percent of the loan—and an annual maintenance fee. Sometimes lenders will waive these, however, so be sure to ask.

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 because closing costs are less than with a refi.

Key Takeaways

  • 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. 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 up front. You’re never paying interest on more borrowed funds than you actually use at any one time.
  • Refinancing can be ideal if you intend to remain in your home for some considerable time and your interest rate will drop.