Is It Better to Get a Home Equity Loan or Refinance?

Homeowners often leverage home equity for financial needs, from large expenditures to adjusting mortgage terms. Home equity loans and refinancing are two common tools for this. Both allow individuals to access their property’s value, but they operate distinctly and serve different financial objectives. Understanding these differences is key to making an informed decision.

Understanding Home Equity Loans

A home equity loan functions as a second mortgage, allowing a homeowner to borrow a lump sum against their property’s accumulated equity. This loan is separate from the primary mortgage and creates a distinct debt obligation. Funds are disbursed in a single payment at closing, providing immediate capital. Home equity loans feature a fixed interest rate, ensuring predictable monthly payments over a set repayment period, typically 5 to 20 years.

This structure suits homeowners needing a specific amount for a defined purpose. Common uses include financing home improvements, consolidating higher-interest debt, or covering large, one-time expenses like educational costs. The loan is secured by the home, acting as collateral similar to the original mortgage.

Lenders determine eligibility and loan amount using the loan-to-value (LTV) ratio. They assess the combined loan-to-value (CLTV) ratio, which includes the existing first mortgage and the new home equity loan, against the home’s appraised value. Lenders allow borrowing up to 80% to 90% of the home’s combined equity, considering the first mortgage balance. For example, if a home is valued at $400,000 with a $200,000 mortgage, a lender might allow a home equity loan that, combined with the first mortgage, does not exceed 80% of the home’s value ($320,000), permitting a loan of up to $120,000.

Understanding Refinancing Options

Refinancing replaces an existing mortgage with a new one, often with revised terms. This pays off the old loan, and the homeowner starts a new mortgage with a fresh interest rate, repayment period, and potentially a different loan amount. It adjusts the primary housing debt instead of adding a separate loan.

There are two primary types of refinancing. A “rate-and-term refinance” secures a lower interest rate or alters the loan’s repayment period, such as changing from a 30-year to a 15-year mortgage. This aims to reduce monthly payments or pay off the loan faster, without accessing additional cash.

A “cash-out refinance” allows homeowners to borrow more than their outstanding mortgage balance, receiving the difference as a lump sum. This option leverages home equity by increasing the new primary mortgage amount. The cash can then be used for various purposes, similar to a home equity loan.

Lenders set a maximum loan-to-value (LTV) ratio for cash-out refinances, often permitting borrowers to access up to 80% of their home’s value, though some allow up to 90%. For example, if a home is valued at $300,000 with a $100,000 mortgage, a lender might allow a new mortgage up to $240,000 (80% of $300,000), providing $140,000 in cash. Common reasons for refinancing include lowering monthly payments, shortening the loan term, or extracting cash from home equity.

Key Factors for Choosing Between Them

Choosing between a home equity loan and refinancing depends on specific financial goals and individual circumstances. Both options access home equity, but their structures and implications differ, impacting financial planning and long-term costs.

Financial Goal

The homeowner’s financial goal is a primary consideration. If a lump sum is needed for a specific, one-time expense, such as a major home renovation, a home equity loan might be more suitable. This provides the exact amount without altering the existing first mortgage. Conversely, if the objective is to reduce the current monthly mortgage payment or shorten the loan term, a rate-and-term refinance is often the more direct approach.

Interest Rate Structures

Interest rate structures also play a role. Home equity loans come with a fixed interest rate, providing predictable monthly payments throughout the loan term. This predictability is advantageous in a rising interest rate environment, as the payment amount will not change. Refinancing, including cash-out refinancing, can result in either a fixed or variable interest rate for the new primary mortgage. While a variable rate might offer a lower initial payment, it introduces the risk of increased payments if market rates rise.

Costs and Fees

The costs and fees associated with each option are another factor. Refinancing involves closing costs, which can range from 2% to 6% of the new loan amount. These costs may include appraisal fees, origination fees, title insurance, and attorney fees, similar to those incurred with the original mortgage. For a $200,000 refinance, these costs could range from $4,000 to $12,000. Home equity loans also have closing costs, ranging from 2% to 6% of the loan amount, but these can sometimes be lower than those for a full mortgage refinance. Some lenders may offer home equity loans with no closing costs, though this might involve a higher interest rate.

Impact on Existing Mortgage

The impact on the existing mortgage is a key difference. A home equity loan is a separate, second mortgage, meaning the terms of the original mortgage remain unchanged. The homeowner will have two distinct mortgage payments. In contrast, refinancing replaces the entire original mortgage with a new one, consolidating the debt into a single loan and payment. This can simplify financial management but may also restart the loan term, potentially extending the overall repayment period.

Tax Implications

Tax implications also warrant consideration. For both home equity loans and cash-out refinances, the interest paid may be tax-deductible under specific conditions. According to Internal Revenue Service (IRS) guidelines, interest on home equity debt is deductible only if the borrowed funds are used to “buy, build, or substantially improve” the home securing the loan. This deduction is subject to mortgage debt limits, up to $750,000 for married couples filing jointly and single filers. If the funds are used for personal expenses, such as credit card debt or college tuition, the interest is not deductible. For a cash-out refinance, only the interest on the portion of the loan used for qualifying home improvements is deductible.

Credit Score Considerations

Credit score considerations are also relevant. A strong credit score, above 700, is important for securing favorable interest rates and terms for both home equity loans and refinances. Lenders view higher scores as an indication of lower risk, leading to better loan offers. Applying for either loan involves a hard inquiry on a credit report, which can temporarily lower a credit score by a few points. This impact is short-lived. Maintaining timely payments on the new loan can positively impact credit scores over time.

Time Horizon

The homeowner’s time horizon is a consideration. If the homeowner plans to sell the home soon, the upfront costs of refinancing might outweigh the benefits of a lower interest rate. The longer a homeowner stays in the home, the more time there is to recoup closing costs through reduced monthly payments. For home equity loans, the repayment period is shorter than a full mortgage, which might be preferable for those seeking to pay off the debt quicker.