What Is the Difference Between Refinance and Home Equity Loan?

Homeownership involves navigating financial decisions, especially when leveraging home equity or adjusting mortgage terms. Homeowners often explore options to access funds for significant expenses or to improve their financial standing. Mortgage refinancing and home equity loans are two common financial tools for these purposes, each serving distinct needs.

What is Mortgage Refinancing

Mortgage refinancing replaces an existing home loan with a new one. This process allows homeowners to secure different terms, such as a new interest rate, a revised repayment period, or a different loan type. The goal of refinancing is to improve the financial conditions of the original mortgage.

Homeowners consider refinancing to obtain a lower interest rate, which can reduce monthly payments and decrease the total interest paid over the loan’s life. Another reason is to change the loan term, for instance, shortening a 30-year mortgage to 15 years to pay off the loan faster, or extending a term to lower monthly payments. Converting an adjustable-rate mortgage (ARM) to a fixed-rate mortgage is also a popular objective, providing predictable monthly payments and protection against future interest rate increases.

Two main types of refinancing exist: rate-and-term refinance and cash-out refinance. A rate-and-term refinance adjusts the interest rate, the loan term, or both, without providing additional cash to the borrower. The new loan replaces the old one with more favorable terms, maintaining the existing principal balance. This option is pursued when market interest rates have dropped or a homeowner’s credit profile has improved.

A cash-out refinance allows homeowners to access a portion of their home equity as a lump sum. The existing mortgage is replaced with a new, larger mortgage. The difference between the new loan amount and the remaining balance of the original loan is disbursed to the homeowner in cash. This cash can be used for home improvements, debt consolidation, or other financial needs.

To qualify for a cash-out refinance, lenders require a homeowner to maintain a certain amount of equity, often around 20% of the home’s value, after the new loan is issued. The new loan amount is based on the home’s appraised value and the borrower’s financial profile. A cash-out refinance results in a higher loan balance and potentially a higher monthly payment compared to the original mortgage.

What are Home Equity Loans and Home Equity Lines of Credit

Home equity loans (HELs) and home equity lines of credit (HELOCs) allow homeowners to borrow against the equity accumulated in their homes. Equity is the difference between the home’s current market value and the outstanding mortgage balance. Both HELs and HELOCs use the home as collateral, meaning the property is at risk if the borrower defaults on payments.

A home equity loan is often called a second mortgage. It provides a borrower with a single lump sum upfront. This loan features a fixed interest rate, ensuring monthly payments remain consistent throughout the repayment period. Repayment terms for home equity loans range from 5 to 30 years. Funds can be used for large, one-time expenses, such as significant home renovations, medical bills, or educational costs.

A home equity line of credit (HELOC) functions like a revolving line of credit, similar to a credit card. Instead of a single lump sum, a HELOC allows homeowners to borrow money as needed, up to a predetermined credit limit. Borrowers pay interest only on the amount drawn from the line of credit, not the entire approved limit.

HELOCs have a variable interest rate, meaning the rate can fluctuate over time, often tied to an index like the U.S. Prime Rate. This can lead to changes in monthly payment amounts. A HELOC has two distinct phases: a draw period and a repayment period.

During the draw period, which lasts between 5 and 10 years, the homeowner can access funds, repay them, and borrow again as needed, paying only interest on the borrowed amount. Once the draw period ends, the HELOC transitions into the repayment period, lasting 10 to 20 years. During this phase, borrowing is no longer permitted, and the homeowner must repay both the principal and interest on the outstanding balance, often resulting in higher monthly payments than during the draw period. Both home equity loans and HELOCs create a second lien on the property, meaning they are subordinate to the primary mortgage.

How Refinancing Differs from Home Equity Options

The distinction between mortgage refinancing and home equity options lies in their impact on the primary mortgage. Refinancing replaces the original mortgage with a new loan, altering the terms of the main housing debt. Home equity loans and HELOCs are separate, secondary loans taken out in addition to the existing primary mortgage, leaving the terms of the first mortgage unchanged.

A cash-out refinance provides a new, larger primary mortgage, with the difference paid to the borrower as a lump sum. A home equity loan also offers a lump sum, but it is a standalone second loan. A HELOC provides a revolving line of credit, allowing flexible withdrawals over time, similar to a credit card. A HELOC offers ongoing access to funds, while a cash-out refinance or home equity loan provides a one-time disbursement.

Interest rate structures differ. While a refinanced mortgage can be fixed or variable, cash-out refinances may have slightly higher rates than rate-and-term refinances due to the increased loan amount and risk for the lender. Home equity loans feature fixed interest rates, providing predictable payments. HELOCs have variable interest rates, which can lead to fluctuating monthly payments.

The payment structure is another difference. With a refinance, the homeowner makes a single monthly payment on the new primary mortgage. For home equity loans and HELOCs, borrowers make an additional, separate monthly payment on the second loan, in addition to their existing primary mortgage payment. This results in two distinct mortgage-related payments each month.

Closing costs are involved with both. Refinancing incurs closing costs comparable to those of the original mortgage, ranging from 2% to 5% of the loan amount. Home equity loans and HELOCs have lower closing costs than a full mortgage refinance, sometimes as low as 1% of the loan principal, though some lenders may waive origination fees for a slightly higher interest rate.

The purpose for which these products are used also varies. Refinancing is pursued to secure a lower interest rate, shorten a loan term, or convert an adjustable rate to a fixed rate, directly impacting the main mortgage. Home equity options are used to access cash for specific needs without altering the terms of the primary mortgage.

Aligning Your Financial Goals with the Right Option

Choosing between refinancing and home equity options depends on a homeowner’s financial objectives and current circumstances. Each tool addresses different needs, and understanding these alignments is important for an informed decision.

For homeowners aiming to lower their monthly mortgage payment or reduce the overall interest paid on their primary mortgage, a rate-and-term refinance is suitable. By securing a lower interest rate or extending the loan term, a refinance can directly impact the largest housing expense. This approach is effective when market interest rates are lower than the existing mortgage rate.

When a homeowner needs a large sum of cash for a specific, one-time expense, such as a major home renovation, a cash-out refinance or a home equity loan are options. A cash-out refinance can provide a larger lump sum by replacing the entire primary mortgage, potentially at a lower overall interest rate than a second mortgage, as it is a first lien. A home equity loan offers a distinct, fixed-rate lump sum without disturbing the existing first mortgage.

For those needing access to funds for ongoing or unpredictable expenses, such as college tuition over several years or recurring medical costs, a Home Equity Line of Credit (HELOC) is often appropriate. The revolving nature of a HELOC allows borrowers to draw funds as needed, repay them, and draw again, providing flexibility for staggered expenses. Interest is only paid on the amount borrowed, not the entire credit limit.

Consolidating high-interest debt, such as credit card balances or personal loans, is another common financial goal that both cash-out refinances and home equity options can address. A cash-out refinance can roll debts into a single, potentially lower-interest mortgage payment, simplifying finances. Home equity loans and HELOCs can also be used for debt consolidation, leveraging the home’s equity to secure funds at rates lower than unsecured debt.

Interest paid on home equity loans and HELOCs may be tax-deductible under specific conditions. For loans taken out after December 15, 2017, the interest is deductible only if the funds are used to buy, build, or substantially improve the home that secures the loan. This deduction is subject to a mortgage debt limit of $750,000 for married couples filing jointly or $375,000 for single filers, encompassing both the primary mortgage and any home equity debt. These rules are currently set to extend through 2025, and the decision on which option to pursue should align with an individual’s financial goals, current mortgage terms, and how they intend to utilize the funds.