Which Is Better: a Home Equity Loan or Refinance?

Homeowners often leverage home equity for various financial needs, such as renovations or debt management. Home equity loans and mortgage refinancing are two common tools. Both allow access to a home’s built-up value, but they operate distinctly and serve different financial objectives. Understanding their characteristics is important.

Understanding Home Equity Loans

A home equity loan allows borrowing against a property’s accumulated equity. This loan functions as a second mortgage, separate from the primary mortgage. Funds are disbursed as a single, lump sum payment to the borrower.

Repayment involves a fixed interest rate and consistent monthly payments over a predetermined period. Loan terms commonly range from 5 to 30 years, for predictable budgeting. The home serves as collateral for both the primary mortgage and the home equity loan.

The process generally takes two to eight weeks from application to funding. Common uses include financing home improvements, consolidating higher-interest debt, or covering large, one-time expenditures. Interest paid may be tax-deductible if used to buy, build, or substantially improve the main or second home that secures the loan, subject to limitations.

Understanding Refinancing

Refinancing replaces an existing mortgage with a new one, often with different terms. This allows homeowners to adjust their interest rate, change the loan term, or convert their loan type, such as moving from an adjustable-rate to a fixed-rate mortgage.

A common form is a “cash-out refinance,” where the new mortgage is for a larger amount than the outstanding balance. The difference is provided to the borrower in a lump sum. These funds can be used for various purposes, including home improvements or debt consolidation.

Interest paid on a refinanced mortgage, particularly if it qualifies as “acquisition debt” used to buy, build, or substantially improve a home, is generally tax-deductible, subject to IRS limitations. The application and closing process typically spans 30 to 45 days, though it can sometimes extend up to eight weeks.

Key Distinctions

A fundamental difference lies in their impact on the primary mortgage. A home equity loan is a separate, additional loan that creates a second lien, leaving the original mortgage intact. Refinancing replaces the original mortgage entirely with a new one, establishing a new primary lien.

Both options provide a single lump sum of cash. A home equity loan provides funds disbursed at closing, repaid over a set period. A cash-out refinance involves taking out a new, larger mortgage, with additional funds distributed to the borrower.

Interest rate structures also differ. Home equity loans typically feature a fixed interest rate, providing predictable monthly payments. Refinanced mortgages can have either fixed or adjustable interest rates, and their rates are generally lower than those of second liens because they are the primary mortgage.

Closing costs are an important consideration for both options. For home equity loans, these costs commonly range from 2% to 6% of the loan amount, including fees for appraisals, credit reports, and document preparation. Refinancing also incurs closing costs, generally ranging from 2% to 6% of the new loan amount, covering expenses such as origination fees, appraisal fees, and title services.

Repayment terms differ. Home equity loans typically have shorter repayment periods, often 5 to 30 years. Refinanced mortgages commonly have longer terms, usually 15 or 30 years, aligning with traditional mortgage durations.

Choosing the Right Option for Your Goals

Choosing between a home equity loan and refinancing depends on financial objectives and current circumstances. When the goal is to access cash without altering the existing first mortgage, a home equity loan is often suitable. This is advantageous if the current mortgage has a low interest rate a homeowner wishes to preserve.

A home equity loan may also be preferred for smaller borrowing needs, as its closing costs can sometimes be less substantial compared to a full mortgage refinance. Its fixed interest rate provides stability, ideal for financing a defined project like a home renovation.

Conversely, refinancing is more appropriate when the aim is to significantly reduce the interest rate on the primary mortgage, lowering monthly payments over the long term. It is also a tool for changing the loan term, such as shortening a 30-year mortgage to a 15-year one to pay it off faster, or lengthening it to reduce monthly payments. A cash-out refinance can also consolidate high-interest debts into a single, lower-interest mortgage payment.

Other factors influence the decision. The prevailing interest rate environment plays a role; if rates have dropped significantly since the original mortgage was secured, refinancing might offer greater savings. A strong credit score can improve terms for either option, especially for favorable rates on a refinanced mortgage. The amount of available home equity dictates how much can be borrowed, with both options requiring sufficient equity for approval.