Home Equity Loan vs. Refinance: Understanding the Differences
Deciding between a home equity loan or a refinance? Both options give homeowners the flexibility to access the equity in their home with the flexibility to use that money however they see fit.
Additionally, refinancing allows homeowners to lock in a lower interest rate or change the term of their loan.
If you’re trying to decide if a refinance or a home equity loan is right for you, consider your needs and the benefits and risks of both loan options.
What is a home equity loan?
As a homeowner, you have several options for leveraging the accumulated equity in your home, one of which is a home equity loan. A home equity loan is a type of loan that allows homeowners to borrow against the equity in their home.
Lenders typically pay off a home equity loan in one lump sum payment. The biggest advantage of a home loan is its flexibility. Funds can be spent on everything from medical bills, home renovations, and even travel.
Because home equity loans are secured by your home, lenders may give a lower interest rate than they would for personal loans or credit cards. However, defaulting on your loan puts you at risk of foreclosure.
How does a mortgage loan work?
Lender requirements vary, but generally you need:
- At least 15% to 20% equity in your home
- good credit
- Low debt to income ratio
- Source of stable income
Once you’re approved for a home equity loan, your lender will give you documents showing how much you can borrow (up to 85% of the home’s value), the interest rate, and any associated fees.
These fees vary from lender to lender, so it’s a good idea to shop around and compare.
Once the funds are disbursed, you will be required to repay the principal amount of the loan and the fixed rate interest in fixed monthly installments. Depending on the lender, repayment of your home equity loan can take up to 30 years.
Although a shorter term allows you to pay off the loan faster, it means higher monthly payments compared to a 30-year term.
What does refinance mean?
If you refinance a mortgage, you replace your current loan with a new one, usually with a new principal amount and a different interest rate. There are several reasons a homeowner would choose to refinance their mortgage, such as lowering their interest rate, reducing the term of the loan, or gaining equity in their home in the form of cash.
Here are two common types of refinancing:
Refinancing at rate and term: This is a type of mortgage refinance that allows homeowners to change the term and interest rate of their current mortgage by replacing it with a new loan. Homeowners typically choose this option if they’re looking to lower their interest rate, lower their monthly payment, change the type of loan, or change the length of the term.
Refinancing by collection: With a cash refinance, homeowners take out a new mortgage on their home, up to 80% of the value of your home, for more than is owed. This difference is paid at closing and can be used on almost anything. However, this new loan is larger and has its own conditions.
How does refinancing work?
Refinancing a mortgage is similar to the process you went through with your original mortgage. You must apply and qualify for the loan before approval. The lender will assess your financial situation and determine your interest rate based on your level of risk.
It’s also important to keep an eye on closing costs, which can vary. from 2% to 5% of the loan amount.
Let’s say you’re looking to take some of the equity out of your home and decide to use a cash refinance. You bought a $300,000 house many years ago and took out a $200,000 mortgage. Your current balance with your lender is $100,000.
If the value of the property remained the same, you would have at least $200,000 in equity.
You could potentially be approved for $225,000 and use $100,000 to pay the remaining principal. That leaves $125,000 in cash to use as you see fit.
Comparison of home equity loan and refinance
If you compare a home equity loan to a cash refinance, both options allow homeowners to leverage the equity in their property to borrow more money.
A cash refinance replaces an existing loan with a new loan, meaning you only have one loan and one payment to worry about. A home equity loan, also known as a second mortgage, is another loan that must be paid alongside your original mortgage.
Cash refinances are also considered senior loans and usually come with lower interest rates. First-ranking creditors are reimbursed before all other creditors in the event of foreclosure or bankruptcy. A higher interest rate on a home equity loan may be offset by lower closing costs.
If you want to take out equity but are stuck between a home equity loan and a refinance, a cash refinance is a great option if you can get a lower interest rate. A home equity loan may be worth considering if you want to remove a lot of equity or if you cannot find a lower interest rate when refinancing.
Home equity loan or refinance? Ask an Expert at Total Mortgage
When choosing between a home equity loan or a refinance, both options provide homeowners with quick access to cash by leveraging the equity in their home. Still, one option may make more sense than the other depending on your needs and financial situation.
Looking to refinance or take out a home equity loan? Consider Total Mortgage for a quick and personalized mortgage experience. We work with borrowers across the country.
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