Refinancing with a home equity loan

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If you want to refinance your home’s mortgage loan, you have a few options, including a traditional home refinance and a home equity loan. If you’ve built plenty of equity in your property and plan on selling your home within a few years, refinancing a first mortgage with a home equity loan can make sense. Here’s what you should know about a mortgage refinance versus a home equity loan.

Refinance vs. home equity loan: overview

A traditional refinance and a home equity loan are similar in that both loan types evaluate your credit score to determine whether you’re a high-risk borrower. How these loans function, however, is where their distinction lies.

Refinance

A typical mortgage refinance loan pays off the remaining balance on your primary home loan and replaces it with a new mortgage loan. The newly refinanced loan may have a different interest rate and a different repayment timeline, but refinancing terms can be up to 30 years.

To qualify for a traditional mortgage refinance, you’ll typically need a credit score that’s at least 620, according to credit bureau Experian, although some lenders and federal programs may set a lower credit score requirement.

In the best-case scenario, the new loan will end up saving you money — whether through a lower mortgage rate or a shorter term so you spend less on interest over the life of the loan.

But there’s a caveat: There’s no guarantee that your refinanced loan will offer a lower rate, and closing costs can be in the thousands of dollars. Since the cost of refinancing is high, homeowners who choose this option should plan on living in the home in the long term to make up for this expense.

Home equity loan

Home equity loans are often regarded as a way to fund one-time large purchases or projects, like a home improvement. However, home equity loans can also be used as a refinancing tool if you’re hoping to lock in a lower mortgage rate.

By refinancing using a home equity loan, you’re borrowing against the home’s equity — the difference between the market value of your home and what you owe on the loan. You can typically borrow up to 85 percent of your home’s equity, but your ultimate loan amount is also contingent on other financial factors, like your income and the home’s value.

According to Experian, the homeowners usually need a FICO score of 680 or higher to qualify for a home equity loan.

Home equity loan rates may be higher than the rate on a 15-year fixed-rate mortgage. The differences, however, vary significantly from bank to bank and over time. Home equity loans generally have a repayment period of up to 30 years, and some lenders may not charge origination fees, which results in lower (or no) closing costs. Also, home equity loans don’t require mortgage insurance that a conventional refinance might require.

Refinancing with a home equity loan

A refinance and a home equity loan are similar, so the question is: When should you refinance with a home equity loan?

“If you’re only going to be in the house for two or three years, then a home equity refinance is better if you can afford a 15-year payment,” says Mike Henry, Dollar Bank’s senior vice president. “If you have the ability to go through home equity, then it is worth doing because you will be able to recoup the costs faster and pay down the principal faster.”

John Park, Dollar Bank’s vice president of operations, explains that “if you are looking for something where you need a shorter-term loan or maybe you don’t plan on keeping the house for a long period of time, then you could be better off doing a home equity loan because you are not going to pay near the amount of closing costs that you would on a residential mortgage.”

Refinancing with a 15-year mortgage vs. a 15-year home equity loan

In this scenario, refinancing with a home equity loan is cheaper for the first 48 months because closing costs are less. After that, the standard 15-year mortgage costs less.

Refi with 15-year mortgage Refi with 15-year home equity loan
Loan amount $150,000 $150,000
Closing costs $2,400 $600
Interest rate 3.50% 4.00%
Monthly principal and interest $1,072 $1,110
Total cost in first 24 months $28,136 $27,229
Total cost in first 48 months $53,871 $53,857
Total cost in first 60 months $66,739 $67,172

Advantages

Home equity loans have lower closing costs than conventional mortgage refinancing and don’t require private mortgage insurance. They may also offer tax advantages, which can add to their value as a refinancing option.

According to the IRS, the interest on home equity loans is tax deductible if you use the funds to “buy, build, or substantially improve” your home. In other words, when used for a major home project, like the construction of an additional bedroom, or to purchase your home (including refinancing), home equity loans may give you tax benefits.

Banks can offer a streamlined application process for home equity loans, with a quicker closing to suit borrowers’ needs. Generally, the timeline from submitting an application to closing on the loan is between two and four weeks.

Disadvantages

Since home equity loan rates are generally fixed, you’ll be shielded from market changes. This may benefit you if mortgage rates spike, though you won’t be able to take advantage of any rate drops.

Another point to consider when refinancing with a home equity loan is that since the loan amount is subtracted from your starting equity, you’ll own less of your home after closing. And because some lenders impose relatively low caps on loan amounts, it may be challenging to find a suitable home equity loan if you need to refinance a large amount.

Additionally, some home equity loans have prepayment penalties if they are paid off within three years of origination. On the other hand, if you default because you’re unable to make payments toward your home equity loan, your lender can foreclose and seize your home.

When to refinance with a home equity loan

If you’re torn between a conventional refinance and a home equity loan, consider your financial situation. The latter is a particularly good option if you have a lot of equity in the home; with more equity in your home, you can borrow a larger amount to pay off your first mortgage while putting any loan surplus toward another expense, like home improvements.

It may also make sense to use a home equity loan if you find a lender that waives closing costs, which is one of the biggest drawbacks of a traditional refinance. If you can qualify for a significantly lower home equity rate than your current mortgage rate, this refinancing approach may help you save on loan costs.

When not to refinance with a home equity loan

Homeowners with low credit scores may want to consider a traditional refinance, since home equity loans may require a higher credit score. You may also want to avoid home equity loans if you’re unable to find competitive home equity loan rates — even if you pay less upfront with these loans, you may pay more in interest over the life of the loan.

If you’ve signed on a home equity loan but no longer want to move forward with the contract, federal law allows for a three-day cooling off period at no penalty to you. The collateral on the loan must be your primary residence, however. To enact your right to cancel, you must notify your lender in writing before midnight of the third business day.

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