Refinance vs. home equity?

That’s the question you need to ask yourself if you now want to tap some of the home equity you’ve built up over the years.

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For the longest time, you thought the terms were one and the same, but now that you have a great need for a large sum of money (we’ll explore some of those possible needs momentarily), not only do you want to know how the loans differ, but you want to know which product would likely be the most beneficial or suitable for your particular situation.

There’s nothing like home equity to fall back on

First, pat yourself on the back for having enough equity in your home so that you now have several financing options that allow you to pull money out of your home. Perhaps, you bought a home in a rapidly appreciating neighborhood, maybe you put down a sizable (more than 20 percent) down payment when you bought your house, or maybe you have faithfully been paying down your mortgage year after year to the point where your loan balance (what you still owe your lender) is far less than what your home is now worth.

However you did it, your lender will be glad to know you have skin in the game. As for figuring out how much skin or equity that is, simply divide your current loan balance by the value of your home. So, if you have an outstanding loan of $100,000 on a home valued at $400,000, you have a loan-to-value (LTV) of .25 (25 percent). Subtract 25 from 100, and your equity stake is 75 percent. Any figure above 20 percent is solid, so at 75 percent equity, lenders will be beating a path to your door, provided your FICO score also is respectable.

Typical reasons homeowners tap into their equity

You should know that whether you choose to refinance or take out a home equity loan or line of credit (the features of which we’ll share upcoming), you will be putting up your home as a collateral. In other words, if you fail to pay back your loan, per your agreement, you could lose your home. So before examining the refinance vs. home equity debate any further, scrutinize your borrowing motives.

Leveraging the equity in your home can be an excellent low-cost solution to cover college tuition, a medical emergency, job loss, a large tax bill, a major remodeling project or the purchase of a new car to replace the one in your driveway leaking oil, guzzling gas and being held together with baling wire.

But if you’re leveraging your home to go to an elite cooking school when you don’t know the difference between salt and pepper or you want to help your second cousin, who just got out of jail, buy a $5,000 hotdog cart, take pause.

Refinance vs. HELOC debate actually involves three primary products

A refinance means you want to rip up (pay off) your first mortgage and replace it with an entirely new mortgage and loan number. As you did with your old mortgage, you again will be responsible for closing costs, fees and any points associated with the privilege of obtaining a completely new loan.

By contrast, the term “home equity” comprises two different products. One is a home equity loan, the other is a home equity line of credit, popularly known as a HELOC. Both, however, are usually second mortgages, meaning that in addition to retaining your current loan, you are electing to take out a second loan on your home. Typically, closing costs on these second mortgages are minimal, relatively speaking.

With a home equity loan, you usually get your money in one lump sum that you can finance at a fixed rate. A HELOC works more like a credit card because you’re given a maximum spending limit, but you’re charged interest only on the amount you use (draw) during the length of your arrangement (term). The interest rate is often pegged to the prime rate. Because the prime rate can change, a HELOC is an adjustable rate product.

So, should you be in a position to tap your home equity and are strongly motivated to put it to work, you have three choices. Let’s take a closer look at each option.

Refinance solution

As a rule, if you currently have a mortgage rate a full percent higher than today’s current low rates and you plan to own your current home for five years or longer (this is just a benchmark), you’re probably a good candidate for a refinance. Your time horizon is important because you want the savings from your lower loan payments to offset or exceed your closing cost expenses as soon as possible.  With the savings you realize from your new lower monthly mortgage, you can start attacking those deferred housing improvement projects.

Besides refinancing to lower your mortgage rate, you could also choose to shorten the length of your mortgage from, say, 30 years to 15. In this scenario, you likely won’t lower your monthly mortgage payment (they could actually increase), but such a strategy could potentially save you thousands of dollars in interest down the line.

If the rate-and-term refinance options, outlined above, are too conservative for the bold or pressing projects you have in mind, then you might be better suited for a cash-out refinance. As the name implies, a cash-out refinance lets you borrow an amount greater than your current loan. Say your house is worth $200,000 and your mortgage balance is $140,000, giving you 30 percent equity. With a cash-out, you might refinance $160,000, reducing your home equity to 20 percent, but you’ll have $20,000 to finally complete that big-ticket home improvement project on your list. Done correctly, your home improvement project could also raise your home’s resale value.

Every product, of course, contains strengths and weaknesses. Another refinance plus is the accompanying interest rate is lower than a home equity loan. On the downside, you have to be careful that your home equity remains higher than 20 percent. Below that, you will have to pay for costly private mortgage insurance (PMI), which could quickly erode the benefits of your refinance.

Another twist to consider

It’s not unheard of to refinance to a higher-rate mortgage if you intend to pull cash out to pay off your high-interest credit card debt. This strategy, however, involves swapping unsecured credit card debt for secured mortgage debt. Also, the prospect of amortizing your credit card debt over 30 years is a little depressing.

Lastly, you might already have a great low-interest mortgage or one with a few years left on its term, so why change it? That’s why home equity second mortgages were invented to give you the cash you need without discarding or disrupting a perfectly good first mortgage.

Home equity loans get the jobs done

A home equity loan is often used for debt consolidation, major home renovations, or large one-time purchases. Think of it as a one-and-done loan. Your loan amount comes with a fixed rate, term and monthly repayment schedule. For this protection from payment fluctuations, rates for home equity loans can be higher than for HELOCs.

As for comparing a refinance (one mortgage) and home equity loan (a second mortgage on top of your existing first mortgage), you’ll need to consider several factors. At the top of the list, of course, are the monthly payments both products would generate. While most mortgages are set up to be repaid over 30 years, equity loans (and lines of credit) typically have a repayment period of 15 years, although it might be as short as five and as long as 30 years.

Some back-of-the-envelope figuring compares a $100,000 refinance (one mortgage) to a home equity loan of $25,000, tacked on to an existing mortgage of $75,000 (two mortgages). Again, note the $25,000 second is for 5 percent because seconds usually come with higher rates.

Refinance (one mortgage)

  • Monthly payment from refinance of $100,000 at 4.5%, 30 years = $506

Home Equity (two mortgages)

  • Monthly payment from first mortgage of $75,000 at 4.5%, 30 years = $380
  • Monthly payment from second mortgage of $25,000 = $134

Monthly total (over 30 years) = $514

  • But if the second had to be paid off in 15 years (180 payments of $197 each), the home equity loan, including the first mortgage, would rise to $578 monthly
  • Use the MyBankTracker mortgage calculator to give you a better idea of mortgage financing costs

Home Equity Line of Credit adds flexibility

Instead of having to go back to your lender for a new home equity loan each time you have a new remodeling project, you go just once with the idea that you have multiple projects you want to complete over the next decade. Rather than being given a lump sum, the total amount on which you would begin making repayment (as with a home equity loan), you are given a line of credit equal to the lump sum, but you pay interest only on the portion you access for your current need.

Many HELOCs start at the prime rate or prime minus one percent, so initial entry costs are lower than either a refinance or a home equity loan, but at the end of the introductory period, rates are typically tied to the prime rate plus the lender’s margin. For the last year, the prime rate has been anchored at 3.25 percent, but with the lender’s margin of 3 or 4 percent factored in, your HELOC rate could quickly rise to 6.25 or 7.25 percent. And typically there are no caps on HELOCs, as there are with monthly adjustable rate mortgages.

“HELOC rates are ridiculously low right now,” said Kent Sorgenfrey, an Irvine, Calif., lender with New American Funding. “And if the borrower is confident that he can pay more than the required payment or expects to receive a lump sum in the form of a bonus or tax return and is disciplined enough to put it down on the HELOC, he can keep the balance low or pay it off altogether.”

With a low balance, the borrower can repeatedly access his line of credit up to the limit for the length of the draw term.

Despite the possibility of rate fluctuations, having a HELOC in your hip pocket for a rainy day may trump both a refinance or a home equity loan. Imagine, for instance, you had to attend a funeral of a relative or a close friend half way across the country and didn’t have the money for the flight, hotel and car rental. Like a credit card (at lower interest by the way), you tap your line to cover your expenses.

Work up different scenarios with your lender

To better compare the refinance vs. home equity debate, challenge your lender to work up different scenarios to find out which one works for your needs and goals.

Obviously, if you have the opportunity to shift to a lower rate mortgage and plan to remain in your residence for the foreseeable future, a straight refinance or cash-out refinance seems like the logical play. But if you don’t want to touch the term or the rate of your current mortgage, but still need cash now to help you achieve one big goal or five smaller ones, consider a home equity loan or a line of credit.

With changing rates, varying loan terms, and differing loan programs and incentives, there are lots of moving targets to consider and calculate. What shouldn’t waver, however, is your resolve for tapping your home equity when you firmly believe it can help improve your home and your quality of life.

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