Which is Better a Home Equity Loan or Refinance

A mortgage refinance is just one aspect of homeownership that you will need to deal with. However, mortgage refinances go hand in hand with many other aspects that you should be aware of. One aspect is a home equity loan. What is a home equity loan? What’s the difference between a home equity loan and a mortgage refinance? All of these questions and more will be answered in this article!

What is a Mortgage Refinance

In order to understand the difference between a mortgage refinance and a home equity loan, you must first understand a mortgage refinance. A mortgage refinance is just when a homeowner replaces their original mortgage with a new one. The new mortgage will serve its own special purpose whether that be to save the homeowner money, allow the homeowner to get cash out of their home, etc. There are many different types of mortgage refinances but the most common types are:

  • Rate-and-Term Refinance
  • Cash-Out Refinance
  • Cash-In Refinance
  • Streamline Refinance

Rate-and-Term Refinance

This is a type of refinance option that provides borrowers the opportunity to get an improved interest rate and loan terms. These terms can include the type of interest rate (fixed compared to adjustable-rate) and repayment length of the loan. For example, if a homeowner’s original mortgage had a fixed interest rate of 3.5% for 30 years, then after 8 years a mortgage refinance can result in a new loan that has a fixed interest rate of 2.25% with a repayment term of 15 years.

Cash-Out Refinance

When homeowners want to get cash out of their home, they would best benefit from this type of mortgage refinance. In a typical refinance, the new loan replaces the current one based on the remaining loan balance. In a cash-out refinance, the new loan is worth more than the original loan, not just the remaining loan amount. This allows the borrowers to tap into their home equity. Borrowers that choose this option will get the funds during closing.

Cash-In Refinance

You can think of this refinance option as the opposite of a cash-out refinance. Instead of taking cash out of the home, homeowners provide additional money during closing to go towards the overall amount owed to the lender. When homeowners choose this type of refinance, their main goal is to likely improve their loan to value ratio (LTV). Individuals that aim to improve their LTV typically do so to get rid of their private mortgage insurance (PMI) but there are plenty of other reasons to pick this refinance as well.

Streamline Refinance

The refinance process is quite extensive and takes an in-depth look at your financial history. This can make it hard for some homeowners to qualify for a conventional mortgage refinance. That is why streamline refinances can be so helpful. These refinances feature easier credit requirements, limited verifications, no appraisal needed for approval, less paperwork, more affordable closing costs, and an overall faster processing time! These are only offered as government-backed loans due to the high risk to the lender.

What is a Home Equity Loan

This is a type of loan that provides borrowers the chance to get cash from their home by borrowing against their home equity. To figure out the amount of equity you have you can subtract the remaining balance on your mortgage from the most up to date market value of the home. If you do not have an eligible LTV ratio then you may find that it is difficult to get this loan option. These loans are also referred to as a second mortgage (and they are not considered a refinance!) The average home equity loan has very similar terms and conditions of a conventional mortgage. Homeowners choose this type of loan when they want to tap into their home equity. However, there is a refinance option that does this as well. If you have more than one option to achieve a goal, it is best to compare them to see which is the best choice for your financial situation.

Types of Home Equity Loans

Homeowners interested in tapping into their home equity can choose between a variety of home equity loan options. The three popular home equity loans are:

  • Home Equity Loan
  • Home Equity Line of Credit (HELOC)
  • Hybrid Equity Loan

Each of these options serve a similar purpose but are a bit different from one another.

Home Equity Loan

This is a type of loan that lets homeowners tap into their home equity by borrowing against it. This loan is a second mortgage and will not have any impact on the existing mortgage. The terms of these loans vary by financial institution but typically can be repaid over the course of 5 to 30 years and have a fixed rate.

Home Equity Line of Credit (HELOC)

Homeowners can tap into their home equity with a line of credit. This is a revolving, open line of credit that acts nearly identically to a conventional credit card. Homeowners choose this option because of the fact that these cards tend to have more benefits and lower interest rates (compared to a “normal” credit card.) Essentially, this is a secured credit card that uses the home as collateral. However, a HELOC still has an underwriting process to go through due that fact.

You can expect these cards to have a variable interest rate and initial draw period. During an initial draw period, the borrower can only make payments towards interest. This period can last a whopping 10 years! Some pros of an HELOC include the fact that you only pay interest on the funds that you use, there are usually lower closing costs, and they are a nice option when you are in need of funds for an emergency. However, some of the drawbacks of this card include the fact that it is a variable rate which can be hard to budget for.

Hybrid Equity Loan

The final popular option is a hybrid equity loan. This is a HELOC that has a similar structure to a fixed-rate home equity loan. Basically the homeowner can expect the HELOC interest rate to be fixed instead of variable. It takes the best of both options and combines them. Homeowners tend to choose this option due to the low interest rates, and manageable monthly payments that are easy to budget for. Unfortunately, a hybrid equity loan will still likely have a higher rate than a cash-out refinance.

Different Types of Loans 

When trying to figure out which home equity loan you should choose, there are a few factors that you can consider when making your decision.

  • Interest Rates and Fees
  • Market Volatility

Interest Rates and Fees

Interest rates are a very important component to consider when reviewing loans. You want to see how different lenders offer different interest rates and have different fees associated with the loan.

Market Volatility

It is important to be aware of external influences. Unexpected situations, like the COVID-19 pandemic for example, will likely result in a change to home equity products. A borrower can expect to have more limited loan options, loan amounts, and strict qualifying criteria. These measures protect lenders but can make it more difficult for borrowers.

Which is Better, a Home Equity Loan or Cash-Out Refinance? 

A cash-out refinance and a home equity loan both have similarities and differences. These factors can be what determine which option you choose. Some similarities between these two options are:

  • Fast Funds
  • Access Home Equity
  • Restrictions

While these are some characteristics that these two options have in common, there are some key differences:

  • The Type of Loan
  • Interest Rates

Similarities Between These Two Options

When comparing the best option for your finances, you need to be aware of the similarities and differences.

Fast Funds

With both of these options, you are able to get the funds very quickly. Regardless of your choice, you will receive the funds during closing.

Access Home Equity

These are both a type of secured loan which means that there is collateral to secure the loan. In both cases, the home is used as collateral if you are to default.

Restrictions

A majority of lenders will have systems in place that block a borrower from accessing all of their home equity. They usually require that the borrower leaves some home equity which can help prevent financial hardship.

Differences Between These Two Options

While similarities are important to keep in mind, differences are important as well. This can show you what truly makes these options unique within themselves even if they seem very similar.

The Type of Loan

There are two types of loans. There are first loans and second loans. When you get a cash-out refinance, your existing mortgage is paid off and you get a new one. However, a home equity loan is completely separate from your mortgage and adds an additional payment that you need to be responsible for. You can have a mortgage and a home equity loan while a cash-out refinance just “updates” your existing mortgage loan.

Interest Rates

While the interest rate that you will have on your loan depends on a variety of factors, you can expect a cash-out refinance to have a lower interest rate than a home equity loan. That is because of the fact they are first loans (compared to a second loan).

How to Choose the Best Option for your Financial Situation

When making a decision about what is best for your financial situation, you need to think about many factors, not just one. Some factors to keep in mind are:

  • The amount of home equity you own.
  • The total amount that you want to borrow.
  • How long your loan will be.
  • The purpose of the funds.
  • The interest rate.

Simply put, borrowers that want more predictable monthly payments, can afford a second monthly mortgage payment, and want to tap into their home equity without changing their existing mortgage should choose a home equity loan.

If a borrower needs to improve the stability of their budget, get a better interest rate, and improve the terms of their current mortgage while tapping into their home equity then they should choose a cash-out refinance.

Overall

Both a home equity loan and a cash-out refinance provide borrowers the opportunity to tap into their home equity. However, the biggest difference is the fact that if you get a cash-out refinance then the original loan will be replaced by a new loan. On the other hand, a home equity loan can be opened as an unrelated loan compared to your mortgage. Both of these options have their pros and cons depending on your current financial situation, not one is automatically “better” than the other. You can also speak to a financial professional and they can provide more information to help you make a better decision.

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