Home Equity Loan vs. Refinance: What’s the Difference?

Both may be good options for homeowners

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The more you’ve paid toward your home mortgage, the more financial options you have. Home equity loans and refinances are two of these options to get cash out of your homeownership.

The two aren’t one and the same though. While both rely on the equity you’ve built in your home, the similarities between these financial products stop there. From how they’re used and when to use them, to what they cost and how to repay them, home equity loans and refinances are starkly different options, each with their own pros, cons, and best uses.

Home Equity Loans

Home equity loans allow you to tap into the equity you have in your home. You can use the money to pay for home repairs or renovations, college tuition, medical bills, or any big expenses you might be dealing with. Essentially, a home equity loan is a second, smaller mortgage.

For example, let’s say your home is worth $250,000. You have $180,000 left to pay on your mortgage. The difference in value between your home’s worth and your mortgage balance—$70,000—is your home equity. You could take out a home equity loan to access part of this $70,000 in cash.

The amount of the home equity loan is often capped at a lower amount than the actual home equity that you’ve built in your home—often 85% of the equity in your home. So if you’re home equity is $70,000, you may only be able to access a home equity loan of up to $59,500. It also depends on your income, credit score, and other financial factors.

How They Work

Because home equity loans are essentially second mortgages, they work much like your first. You’ll choose a lender, fill out an application, send over your documentation, await approval, and close on the loan. You’ll get a lump-sum payment for your loan amount, which you’ll pay back month by month as you do with your initial mortgage. Usually, you’ll need to pay back your home equity loan within 15 years (or sooner, depending on your loan term).

Costs 

Home equity loans generally come with higher rates than mortgages or refinance loans because they’re second-lien loans. This means if you fail to pay back your loan, the lender on your initial mortgage has first claim to the property—not your home equity lender. This makes them a higher risk. Therefore, higher interest rates offer lenders added protection.

While you might pay a higher interest rate, some home equity loan lenders may waive all or part of the closing costs.

Refinances

Unlike a home equity loan, a refinance isn’t a second mortgage. Instead, it replaces your existing home loan. If you refinance into a longer-term loan or a lower interest rate, it can mean a smaller monthly payment and less interest paid over time. You can also refinance to switch from an adjustable rate mortgage to a fixed rate mortgage so you can lock in a lower rate for the long haul.

A cash-out refinance is different than a regular refinance in that you can tap part of the home equity you have by taking out a loan larger than your current balance.

For example, let’s say your home is worth $250,000, and you have $180,000 left to pay on the loan. In a regular refinance, you’d be able to take that $180,000 and spread it out across a new 30-year period, which could lower your monthly payment.

In a cash-out refinance, you’d be able to access part of that $70,000 home equity by simply refinancing into a new loan that’s larger than your current balance. If you refinanced into a $230,000 loan, for example, you’d get a lump sum of $50,000 ($230,000 - $180,000). 

In some cases, you may even want to use your refinance to consolidate higher-interest debt. If you have high balances on credit cards or other loans, you can use your refinanced mortgage to pay these off, rolling them into your loan balance and spreading the repayment costs out over time. Because mortgages typically have lower interest rates than credit cards and auto loans, this could save you a lot in interest over time.

How They Work

Because a refinance replaces your existing mortgage loan, you won’t be getting a second mortgage payment, but your current payment will change. Depending on the interest rate you qualify for, the length of the loan you choose, and the amount you take out, your payment could be higher or lower. Like a conventional mortgage, you can choose to repay the refinance over the course of 15 or 30 years.

Costs and Applying

Refinance loans are generally easier to qualify for because they’re a first-lien loan. That means the lender has first claim to the property if you default on your loan. Though refinancing often comes with a lower interest rate than a home equity loan, it won’t necessarily be a lower rate than the one on your current loan. Freddie Mac is one source for current average interest rates.

Additionally, check your current mortgage to see if there is a prepayment penalty. If there is, you may need to pay it before refinancing. Ask your current mortgage servicer if the fee can be waived if you refinance with them instead of a new company.

Home Equity Loan vs. Refinance

Refinance

  • Replaces your existing mortgage loan

  • May be easier to qualify for

  • Can be repaid over 15 or 30 years

  • Potentially lower interest rates

  • Can offer you a lump sum, based on your home equity

  • Can be used to consolidate higher-interest debt

Home Equity Loan

  • Acts as a second mortgage

  • May be harder to qualify for

  • Generally need to be paid back sooner

  • Higher interest rates

  • Can offer you a lump sum, based on your home equity

  • Typically closes faster

The Application Process

As with a conventional mortgage application, you’ll need to provide many financial and personal documents during the application process for both a home equity loan and a refinance. These often include W-2 statements, proof of employment history, your Social Security number, and more. You may also need information like your most recent mortgage statement, proof of your home’s valuation, any liens against your home, and more.

Which Is Right for You?

Both home equity loans and refinances can have financial benefits. To determine the best option for your household, you’ll want to take your total home equity into account, as well as your goals, preferred repayment timeline, and how long you plan to stay in the home. 

Regardless of which route you choose, be sure to shop around for the best rate, as rates and closing costs can vary greatly from lender to lender.

Article Sources

  1. PHH Mortgage. "Borrowing Basics: Home Equity Loans vs. Cash Out Refinancing." Accessed Dec. 17, 2019.

  2. Consumer Financial Protection Bureau. "What Is a Second Mortgage Loan or 'Junior-Lien'?" Accessed Dec. 17, 2019.

  3. Washington State Department of Financial Institutions. "Mortgage Refinancing Basics." Accessed Dec. 17, 2019.

  4. Discover. "Refinance 101." Accessed Dec. 17, 2019.

  5. FDIC. "State Housing Finance Agencies: First-Lien Mortgage Products." Accessed Dec. 2019.

  6. Citi. "The Refinance Application Process." Accessed Dec. 17, 2019.

  7. Discover. "Steps in the Home Equity Loan Application Process." Accessed Dec. 17, 2019.