Home Equity Loan vs. Refinance: Understanding the Differences

Deciding between a home equity loan vs. refinance? Both options give homeowners the chance to access their home’s valuable equity with the flexibility to use that cash however they please. 

Additionally, refinancing allows homeowners to lock in a lower interest rate or change the length of their loan term.

If you’re trying to figure out whether a refinance or a home equity loan is right for you, consider your needs as well as the advantages and risks of both loan options.

What Is a Home Equity Loan?

As a homeowner, you have several options for taking advantage of the built-up equity in your home — one of those being a home equity loan. A home equity loan is a type of loan that allows homeowners to borrow against the equity in their homes. 

Lenders typically pay out a home equity loan in a lump sum payment. The biggest advantage of a home equity loan is its flexibility. The funds can be spent on anything from medical bills, home renovations, and even travel. 

Since 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 Home Equity Loan Work?

Lender requirements vary, but you generally need:

• At least 15% to 20% equity in your home
• Good credit
• Low debt-to-income ratio
• Steady source of income

Once you’re approved for a home equity loan, your lender will give you documents stating the amount you can borrow (up to 85% of the home’s value), the interest rate, and associated fees. 

These fees vary from lender to lender, so it’s a good idea to shop around and compare. 

After the funds are disbursed, you will need to repay the loan’s principal amount and fixed-rate interest in fixed monthly payments. Depending on the lender, repayment on your home equity loan can be as long as 30 years. 

While a shorter term allows you to repay the loan faster, it means higher monthly payments compared to a 30-year term. 

What Does It Mean to Refinance?

If you refinance a mortgage, you’re replacing your current loan with a new one, usually with a new principal amount and a different interest rate. There are several reasons why a homeowner would choose to refinance their mortgage, such as lowering their interest rate, shortening the term of the loan, or taking out equity in their home in the form of cash. 

Here are two common types of refinancing:

Rate-and-term refinance: 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 generally choose this option if they are looking to lower their interest rate, reduce their monthly payments, change the loan type or change the term length.  

Cash-out refinance: With a cash-out refinance, homeowners take out a new mortgage on their home, up to 80% of the value of your home, for more than what is owed. This difference is paid out at closing and can be used on almost anything. However, this new loan is larger and comes with its own terms. 

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 risk level. 

It’s also important to keep an eye on closing costs, which can range from 2% to 5% of the loan amount.

Let’s say you’re looking to take out some equity in your home and decide to use a cash-out refinance. You purchased a $300,000 house many years ago and took out a mortgage for $200,000. Your current balance with your lender is $100,000.

If the property value 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. This leaves $125,000 in cash to use as you please. 

Comparing Home Equity Loan vs. Refinance

If you’re comparing a home equity loan vs. a cash-out refinance, both options allow homeowners to leverage their home equity to borrow more money. 

A cash-out 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-out refinances are also considered first-lien loans, and typically come with lower interest rates. First-lien debt holders are repaid before all other debt holders in the event of a 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 some equity but you’re stuck deciding between a home equity loan vs. refinance, a cash-out refinance is an excellent option if you can lock in a lower interest rate. A home equity loan may be worth considering if you want to take out a large portion of equity or if you can’t find a lower interest rate when refinancing. 

Home Equity Loan vs. Refinance? Ask an Expert at Total Mortgage

When deciding between a home equity loan vs. refinance, both options give homeowners quick access to cash by leveraging their home’s equity. Yet, one option may make more sense than the other depending on your needs and financial situation. 

Are you looking to refinance or take out a home equity loan? Consider Total Mortgage for a quick, personalized mortgage experience. We work with borrowers across the country. 

Find a Total Mortgage expert near you.