What Is Better Refinance or Home Equity Loan?

Homeowners often seek ways to leverage their home equity, whether to access funds for various needs or to improve the terms of their existing mortgage. Two common financial tools available for these purposes are refinancing and home equity loans or lines of credit. Understanding the distinct characteristics of each option is important for making informed financial decisions.

Understanding Refinancing

Refinancing involves replacing an existing mortgage with a new one, paying off the original loan and establishing new terms. Homeowners often choose to refinance to secure a lower interest rate, which can lead to reduced monthly payments and significant savings over the loan’s lifetime. They may also change the loan term, either shortening it to pay off the mortgage faster or extending it to lower monthly payments. Converting an adjustable-rate mortgage (ARM) to a fixed-rate mortgage also provides predictability in monthly housing costs.

A “cash-out refinance” is a type of refinancing where the new mortgage is larger than the outstanding balance, with the difference disbursed to the homeowner in cash. This provides a lump sum for major expenses like home renovations, debt consolidation, or educational costs. A refinanced mortgage is fully paid off and replaced by the new loan, resulting in a single mortgage payment.

Refinancing involves closing costs, typically 2% to 6% of the new loan amount, similar to those for a home purchase. These can include appraisal fees, title insurance, origination fees, and recording fees. Interest paid on a refinanced mortgage is generally tax-deductible as home acquisition debt, subject to certain limitations.

Understanding Home Equity Loans and Lines of Credit

Home equity loans (HELs) and home equity lines of credit (HELOCs) allow homeowners to borrow against their home equity without replacing their primary mortgage. These are second mortgages, creating an additional lien alongside the existing first mortgage.

A home equity loan provides a lump sum at closing, typically with a fixed interest rate and repayment schedule, offering predictable monthly payments. HELs are often used for specific, one-time large expenses like major home renovations or debt consolidation.

A home equity line of credit (HELOC), in contrast, functions more like a revolving line of credit, similar to a credit card. Borrowers are approved for a maximum credit limit, and they can draw funds as needed up to that limit during a specified “draw period,” which often lasts 10 years. During the draw period, payments may be interest-only, offering flexibility. Once the draw period ends, a “repayment period” begins, during which the borrower must repay both principal and interest, typically over 10 to 20 years. HELOCs usually have variable interest rates, meaning payments can fluctuate based on market conditions.

Closing costs for home equity loans and HELOCs typically range from 2% to 5% of the loan amount, though some lenders offer options with reduced or no upfront costs by rolling them into the interest rate. Interest paid on a HEL or HELOC can be tax-deductible only if the funds are used to buy, build, or substantially improve the home that secures the loan. Otherwise, the interest is generally not tax-deductible.

Key Distinctions Between Options

Refinancing and home equity products differ fundamentally in their impact on the existing mortgage. Refinancing replaces the original mortgage with a new loan, resulting in a single payment. In contrast, a home equity loan or HELOC adds a second lien, meaning the homeowner will have two separate mortgage payments: one for the original primary mortgage and another for the home equity product.

Access to funds varies significantly. A cash-out refinance provides a single lump sum at closing, similar to a home equity loan. A HELOC offers revolving access to funds up to an approved credit limit, allowing borrowers to draw money as needed. A lump sum suits a single large expense, while a revolving line of credit provides ongoing flexibility.

Interest rate structures are another distinction. Refinancing typically results in a new fixed-rate mortgage, providing consistent monthly payments, though adjustable-rate options exist. Home equity loans generally feature fixed interest rates, ensuring predictable payments. HELOCs almost universally come with variable interest rates, leading to fluctuating monthly payments as market rates change.

Closing costs for refinancing tend to be higher (2-6% of the new loan amount) due to replacing the primary mortgage. Home equity loans and HELOCs typically have lower closing costs (2-5%), with some lenders offering no-cost options for a higher interest rate. Loan amount limits also differ. Cash-out refinances typically allow borrowing up to 80% of the home’s value, requiring 20% equity to remain. For home equity loans and HELOCs, the combined loan-to-value (CLTV) ratio can sometimes extend up to 85% or even 100% of the home’s value, depending on the lender and borrower qualifications.

Choosing the Right Option for Your Goals

Selecting between refinancing and a home equity product depends on individual financial objectives. If the goal is to lower the interest rate on the primary mortgage, reduce monthly payments, or change the loan term, a refinance is generally suitable. This approach can be advantageous when current mortgage rates are lower than the existing rate.

When the objective is to access a substantial sum for a one-time expense, such as a major home renovation or debt consolidation, a cash-out refinance or a home equity loan could be appropriate. A cash-out refinance integrates new funds into the primary mortgage, maintaining a single monthly payment. A home equity loan provides a separate, predictable payment alongside the original mortgage. The choice often depends on a preference for one payment or two, and the relative interest rates.

For homeowners seeking ongoing access to funds, a home equity line of credit (HELOC) is typically the most flexible choice. This option is useful for managing intermittent expenses, such as smaller home improvement projects or fluctuating educational costs. The variable interest rate and draw period allow for adaptability, as interest is only paid on the amount borrowed. Aligning the specific financial need with each product’s characteristics is important for an informed decision.