Refinancing Vs. Home Equity Loans

Before comparing refinancing and home equity loans, it is important to understand the basic difference between the two. Refinancing reduces monthly payments, shortens a loan's term, or lowers the interest rate. After refinancing, you still only have one mortgage. Home equity loans provide credit for large purchases such as education, home remodeling, or medical expenses. A home equity loan is a second loan.

Home equity loans use the equity you have in your house as collateral. The money you have already paid toward your home works as a form of revolving credit that you can borrow against. 

After determining your financial situation and what you need to accomplish, you can evaluate the following differences between refinancing and home equity loans. Remember that they are usually used for different purposes.

Amount

Lenders will usually approve refinancing a mortgage for up to 80% of a home's value. For home equity loans, lenders take a percentage of the home's appraised value (often 75%) and subtract from that the balance owed on the existing mortgage. If the home's appraised value is $100,000, the percentage of appraised value would be $75,000. If you still owe $40,000 on the mortgage, the potential credit limit will be $35,000. The lender will also consider your ability to pay and credit history when setting the credit limit. You will most likely be able to borrow up to your credit limit whenever you want, although some may require you to borrow a minimum amount (for example, $300) each time you draw on the line.

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Closing costs

Since refinancing a home is essentially getting a new loan, closing costs need to be paid again. They may be rolled into the loan amount, but they are similar to the ones paid for the first mortgage. Home equity loans also have closing costs that are not included in the APR. They can include application fees and other charges, discount points, and appraisal fees.

Payments

As with most standard loans, after refinancing you will have monthly payments. Home equity loan payments may be set monthly amounts as well with a set amount paid toward principal and interest each month. You may also pay on only the interest during the life of the plan and repay the principal in full at the end of the term, meaning if you borrow $10,000, you will pay that amount back at the end. Using the credit can vary, but most home equity loans will provide special checks or credit cards to draw on the line.

Interest

Refinancing will lower your APR from its current amount. The exact amount will depend on the market and your credit, but its purpose it to reduce interest. The interest can also be fixed or adjustable. Home equity loans tend to have a higher interest rate than a first mortgage. The interest can also be fixed or variable, but if it's variable, there must be a cap on the increase.

Risks

When refinancing, if you fall too far behind on payments lenders can foreclose your home. Some people don't realize that the same can happen with home equity loans. Home equity loans use your house as collateral. This means that if you default on the home equity loan, the lender can seize your house even if you are making payments on the first mortgage on time.

Time

Typical mortgages and refinances have terms of 15 or 30 years. Home equity loans are usually set up for 15 years although it can be as short as 5 or as long as 30.