Homeowners frequently utilize the equity of their house when they require additional money for debt consolidation, house repairs, or unanticipated expenses. Two common approaches for achieving this are home equity loans and refinancing. Although both choices let you access money, they are best for different situations and operate in various ways.
This guide will help you decide which of refinancing and home equity loans best fit you by outlining their advantages and disadvantages.
What Is Refinancing?
Refinancing is the process of replacing a new, typically better-terms mortgage for your existing one. You get a new loan to pay off your previous one when you refinance. Refinancing comes mostly of two flavors:
1. Rate-and-term refinance – This changes your interest rate, loan term, or both, but the loan amount stays the same.
2. Cash-out refinance – This lets you borrow more than you owe on your mortgage and take the extra money as cash.
Example of Cash-Out Refinance:
- Your home is worth $400,000, and you owe $250,000 on your mortgage.
- You refinance and take out a new loan for $300,000.
- You use $250,000 to pay off the old loan and get $50,000 in cash.
What Is a Home Equity Loan?
Using the equity of your house, a home equity loan is a second mortgage allowing you a lump sum loan. Unlike refinancing, it adds a fresh loan with separate terms rather than replacing your existing mortgage.
Example of Home Equity Loan:
- Your home is worth $400,000, and you owe $250,000 on your mortgage.
- You take out a home equity loan for $50,000.
- Now, you owe $250,000 on your first mortgage and $50,000 on your home equity loan.
Differences Between Refinancing and Home Equity Loan
Refinancing and home equity loans have some key differences.
- Refinancing (cash-out) replaces your current mortgage with a new one, while a home equity loan adds a second mortgage.
- Refinancing usually offers a lower interest rate than a home equity loan.
- With refinancing, the loan amount is based on your home’s total equity, while a home equity loan depends on the available equity.
- Both options provide a lump sum, but refinancing typically has a repayment period of 15-30 years, while a home equity loan is usually 5-20 years.
Also, if you use refinancing for home improvements, you might be able to deduct the interest from your taxes, but this isn’t an option with home equity loans.
Pros and Cons of Refinancing
Pros:
- Lower interest rate: If rates have dropped since your original loan, refinancing helps you save money over time.
- Consolidation of debts: Refinancing combines your debts into one payment, making it easier to manage and possibly lowering interest.
- Access to more equity: With a larger loan, you can borrow more of your home’s equity for different needs.
- Extended term: A longer loan term lowers your monthly payments, making it easier to manage your budget.
Cons:
- Closing costs: Refinancing comes with high closing costs (2-5% of the loan), which adds extra expenses.
- Resets your loan term: Refinancing resets your loan term, which can extend your debt and increase the total interest.
- Longer approval process: Refinancing takes longer to approve than home equity loans, delaying when you can access funds.
- May lose low original rate: If rates have gone up, refinancing may result in a higher rate than your original loan.
Pros and Cons of Home Equity Loan
Pros:
- Separate loan: A home equity loan lets you keep your current mortgage and interest rate, so you don’t change your terms.
- Fixed interest rate: With a fixed rate, your monthly payment stays the same, making it easier to plan your budget.
- Faster processing: Home equity loans get approved and processed faster than refinancing, giving you quicker access to funds.
- Ideal for one-time expenses: A home equity loan is perfect for covering one-time costs like home renovations or tuition fees.
Cons:
- Higher interest rates: Home equity loans typically have higher interest rates than first mortgages, making them more expensive over time.
- Adds a second payment: A home equity loan adds another monthly payment, which can make your budget harder to manage.
- Risk of foreclosure: If you can’t repay, the lender could foreclose on your home, putting your property at risk.
- Lower loan amounts: Home equity loans usually offer smaller loan amounts than cash-out refinancing, limiting how much you can borrow.
When to Choose Refinancing
A cash-out refinance could be the best choice if:
- Interest Rates Have Dropped: You can lower your monthly payment and get cash.
- You Want to Consolidate Debt: Combining your debts into one mortgage might save you on interest.
- You Plan to Stay Long-Term: Spread out the refinancing closing costs over time.
- You Want to Remove PMI: Refinancing can remove private mortgage insurance if you have enough equity.
Ideal Scenario for Refinancing:
Imagine you bought your home with a 6% interest rate, but now rates are at 4%. By refinancing, you reduce your payment and take out $40,000 for renovations. This helps both your budget and your home’s value. If you’re considering adjusting your mortgage, you can refinance your mortgage to take advantage of the lower rates.
When to Choose a Home Equity Loan
A home equity loan might be the better choice if:
- You Have a Low Rate on Your Mortgage: You don’t want to lose your great rate by refinancing.
- You Only Need a Specific Amount: It works well for fixed-cost projects, like remodeling or paying off debt.
- You Need Funds Quickly: Home equity loans usually have faster approval and funding.
- You’re Comfortable Managing Two Loans: Your finances can handle making two payments.
Ideal Scenario for a Home Equity Loan:
Suppose you have a 3% fixed mortgage and need $30,000 for your child’s college tuition. Instead of refinancing, you take a home equity loan at 6% for 10 years. This way, you keep your low mortgage rate intact.
Tax Implications
You can deduct the interest on both refinancing and home equity loans, but only if you use the funds to “buy, build, or substantially improve” your home. Here’s how it works:
- Home renovations?
You probably can write off the interest if you spend the money on home renovations that raise the value of your house. Projects like remodeling your kitchen, adding a bathroom, or finishing your basement count here. - Paying off credit card debt?
Although combining debt will help you simplify your finances, the IRS does not allow tax deductions for interest paid off non-home linked debt, including credit cards. - Buying a car?
Should you use the loan to buy an automobile, the interest won’t be deductible since buying a car isn’t regarded as a house improvement.
See a tax adviser always to make sure these guidelines apply to your circumstances.
Home Equity Loan vs. HELOC vs. Refinance
Never confuse a HELOC—Home Equity Line of Credit—with a home equity loan. Like a credit card, a HELOC is a revolving credit line on which you borrow just what you need. The three choices go as follows:
- Home Equity Loan
- Type of loan: Lump sum
- Interest rate: Fixed
- Payment structure: Fixed payments
- Use case: For one-time expenses
- HELOC (Home Equity Line of Credit)
- Type of loan: Revolving line
- Interest rate: Variable
- Payment structure: Depends on usage
- Use case: For ongoing expenses
- Refinance (Cash-Out)
- Type of loan: New mortgage
- Interest rate: Usually fixed
- Payment structure: Fixed payments
- Use case: For large cash needs and a better rate
Every alternative serves your financial situation in different ways. Before deciding, be sure you understand the variances.
Need Help Choosing?
See a lender to compare customized offers if you’re not sure which alternative to choose. Bring your credit score, current mortgage information, income, and project plans. This will enable them to provide you customized counsel fit for your circumstances. Walking you through the advantages and drawbacks of every option, a lender can help you decide which one best fits your financial future.
End Note
Your financial goals, present mortgage, and home equity will determine if refinancing or a home equity loan best fits you. Refinance if you need a big sum or wish a reduced rate. If you want a fixed, one-time loan and your present mortgage is satisfactory, a home equity loan is better.
Always run comparisons on terms, fees, and interest rates. See a mortgage professional or financial advisor if you’re not sure to assist with your choice.