The wisdom of getting a home equity loan or refinancing a first mortgage to get the cash a homeowner needs has no right or wrong choice. Circumstances should dictate the most appropriate option. Learning about the components involved and the differences in costs and terms helps homeowners choose the best option for their purposes and situation. A home equity loan (or line of credit) provides cash proceeds to homeowners based on the equity (ownership amount) they have built up in their home. Refinancing involves receiving a new first mortgage while eliminating the existing home loan.
Finance and real estate experts have debated the subject of selecting an equity loan or refinancing one's home for decades. Both sides of the arguments have merits, and either option is the best choice in different situations. When a homeowner needs funds for home improvements, education, medical treatment or other obligations, both equity loans and refinances are good choices, with low interest and favorable terms. Yet, homeowners should examine both options carefully to find the most cost-effective offer.
Some important features of equity loans are fast approvals and closings, low interest rates and closing costs, and tax deductibility (if the proceeds are used for qualifying purposes). Refinancing a home offers the same advantageous interest rates and tax deductibility, while also delivering lower monthly payments because of the longer payback terms (up to 40 years). Unfortunately, additional "features" include higher closing costs and longer approval and closing time periods. While first mortgages typically have lower interest rates, lenders often have home equity loan "sales" at rates comparable with first mortgage loans. Be aware, however, that many home equity loan products offer only variable rates, which may start lower than some first mortgage loans but can increase over time.
Among the considerations when evaluating either a home equity loan or refinance: How long will the owner keep the home? (A short time may dictate using an equity loan.); How are the proceeds to be used? (Consolidating debt may be best with a first mortgage, while home improvements may indicate an equity loan option.); What is the current difference between market interest rates of home equity and mortgage loans? (Equity loan "sales" may offer interest rates equal to first mortgage loans.); Does the homeowner prefer the longer payback offered by refinancing a first mortgage (along with paying more interest over time) or the shorter payback (and lower total interest) of an equity loan? (The monthly payment should fit comfortably into the homeowner's budget.)
The size of the loan needed compared with the homeowner's current monthly cash flow can strongly affect the decision to choose an equity loan or a refinance. For example, if the cash needed is relatively small ($10,000 to $20,000) and the borrower has strong cash flow, an equity loan may be the more cost-efficient, faster and easier option. Conversely, should the borrower need more significant proceeds ($25,000 to $50,000) and is restricted to a "tight" budget, a refinance, with its longer repayment terms, might be a better choice.
Both options are appropriate in different situations. Choosing one option over the other, however, could be significant in the future. For example, choosing to refinance instead of getting an equity loan typically results in thousands of dollars of additional interest cost because of the longer payback terms.
Another significant difference may involve outstanding loan balances and flexibility. Refinancing a home involves disbursing all proceeds and recording a new mortgage loan for the full amount borrowed. However, an equity line of credit allows borrowers to use available funds only as they need them. No interest is charged on the amount of the credit line, only on the amounts used.