Yahoo Finance Refinancing and Home Equity Loans: 5 Key Differences You Should Know
When you have equity in your home — meaning your outstanding home loan balance is less than the house’s value — you can take out loans against that equity. You have two options: refinancing your mortgage or taking out a home equity loan.
With either option, you gain access to cash backed by your home. Use those funds to reach financial goals like paying for education, consolidating your debt or investing in home improvements.
Understanding the differences between refinancing and home equity loans will help you choose the right option for your needs.
Also here are five myths about home equity loans.
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Home Equity Loans and Refinancing Differences
Though home equity loans and refinancing have a lot in common, there are some key differences between them:
Access to Cash
Traditional mortgage refinancing only involves changing the terms of the mortgage. For example, if interest rates drop, you may refinance your loan at a lower rate than when you initially took out the mortgage.
Refinancing may lower your monthly mortgage payment or help you repay the loan faster by changing these terms. However, you don’t gain access to cash through traditional refinancing. The only way to get some back money when refinancing is to do a cash-out refinance.
With cash-out refinancing, you substitute your original mortgage for a new one. The new mortgage is for a higher principal amount than the outstanding balance on your original mortgage. As a result, you can pay off your original mortgage and still have funds left over to use for anything you want.
Home equity loans also give you access to cash based on the equity you have in your home. The difference is that they don’t replace your original mortgage or affect it in any way. Instead, these are entirely separate loans.
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First vs. Second Loan
Your mortgage is the “first loan” on your home. It’s the primary loan. If you default, your first loan provider gets paid before any second loan provider, according to Rocket Mortgage.
Refinancing means changing the terms of your mortgage, whether that’s the principal amount, the interest rate or the repayment period. However, even after you refinance and make changes, that loan remains the primary one on your home.
On the other hand, a home equity loan is a “second loan.” Because lenders of second loans don’t get the same guarantees as first loan providers, rates on home equity loans tend to be higher, as Rocket Mortgage explains. If getting the lowest possible interest rate is your goal, you may be better off refinancing over taking out a home equity loan.
Interest Rates
Interest rates are a major deciding factor when evaluating any type of loan. The higher the interest rates on the loan, the more that loan will cost you.
The interest rate structure also matters when setting your budget. Fixed interest rate loans have the same interest rate throughout the life of the loan, while adjustable interest rate loans shift as market conditions change.
Cash-out refinancing is available with either fixed or adjustable interest rates, so you can choose your preferred interest structure. By contrast, most home equity loans have fixed interest rates, according to Bank of America.
Closing Costs
Beyond the principal amount and interest payments, you may also need to pay closing costs on new loans. Closing costs are the fees and other expenses you pay your lender to process your loan. You want to keep your loan closing costs as low as possible to get the most value from your loan.
Typically, cash-out refinancing has higher closing costs than home equity loans. Expect to pay around 2% to 5% of your loan amount in closing costs with a cash-out refinance. For example, if you’re doing a $300,000 cash-out refinance, you might pay $6,000 to $15,000 in closing costs.
Home equity loans generally have lower closing costs, as reported by CNN, though they vary by lender. When you’re comparing loan options, make sure to include the closing costs so you have a complete picture of what each loan will cost you in total.
Number of Loan Payments
If you choose cash-out refinancing, you will only have one monthly mortgage payment because you only have one loan. Your payment amount will change, but you only have to worry about making one monthly payment.
With a home equity loan, you’re taking on a second loan on your home. You will have two monthly loan payments unless you already paid off your primary mortgage.
People who struggle with organizing their finances and keeping track of due dates may not want to add a second monthly payment.
Should You Choose Refinancing or a Home Equity Loan?
The right option between refinancing and a home equity loan will depend on your financial goals and preferences. Traditional refinancing is the way to go if you just want to pay off your mortgage faster or take advantage of lower interest rates. If you need cash, choose between a home equity loan or cash-out refinancing.
Because cash-out refinancing has higher closing costs, you may want to avoid this option unless you plan to stay in your home for a long time. On the other hand, cash-out refinancing typically has lower interest rates than home equity loans, which can help you save money.
If you’re worried about managing multiple home loans, choose refinancing over home equity loans. That way, you only have one creditor and loan payment to manage monthly.
Taking out a home equity loan may be the right option if you need cash but don’t want to mess with your original mortgage. You can also gain access to cash faster using a home equity loan compared to a cash-out refinance. If you’re in a rush for funds, consider a home equity loan.
Refinancing and home equity loans are both great options for homeowners who want to borrow against the equity in their homes. Compare your options with several lenders to find the best rates and loan terms.
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