Home Equity Loan vs. Refinancing: The Pros and Cons
Let’s start by first defining what a home equity loan is and what it means to refinance and then let’s look at the pros and cons.
Home Equity
Home equity loans are used when you want to borrow a fixed amount against the increase in value of your home over the amount you owe. A home equity loan is typically held in a second lien (second deed of trust), this is because the homeowner typically has an existing loan. However, if the original mortgage had been paid off, the amount of the home equity loan would be secured against the property as a first position lien. A home equity loan can be a first mortgage or a second mortgage!
refinance
The concept of refinancing your mortgage is quite simple: you replace your primary mortgage with an amount greater than the outstanding balance. Therefore, it differs substantially from a home equity loan in that it is similar to getting a brand new mortgage.
Advantages of equities
1. It is common to be able to borrow up to 100% or more of the home’s value, less any outstanding debts or mortgages. There are also lenders who will lend up to 125% in special circumstances and these are known as ‘over principal’ loans.
2. In the United States, under certain circumstances, it is often possible to deduct interest on a home equity loan from personal income taxes. A visit to your accountant or financial adviser may be appropriate to see if you qualify for tax relief.
3. Fees such as appraisal fees, originator fees, title fees, stamp duties, arrangement fees, and closing fees are often included in loans.
Equity Cons
1. A home equity loan creates a lien on the borrower’s home and reduces the security interest in the home. This means that the loan-to-equity ratio, if more borrowing is needed, can only improve through rising property prices.
2. Because it is a debt against your property, a home equity loan is a secured debt. Some borrowers prefer unsecured debt at a higher rate.
3. Most home equity loans require good to excellent credit and a reasonable loan-to-value ratio. The reason for this is simple. If the homeowner is in financial difficulty, and since most home equity loans have a second lien, in a default situation, the primary lien holder gets paid first – the lien holder! Secondary withholding gets the “balance” that remains!
refinance professionals
1. If you refinance your mortgage, you may be able to lower your current rate.
2. It is more beneficial when the rates are lower.
3. Can be attractive to homeowners looking to consolidate other high-interest debt, as there is often less reliance on a borrower’s credit rating than a home equity loan.
Refinancing Cons
1. By doing a 30-year refinance now, you lower your payments, but now your house won’t be paid off for another 30 years.
2. Often a large lump sum is paid at the end of the loan and is called a balloon payment. If you can’t make the balloon payment or refinance, you face foreclosure and the loss of your home.
3. There may be hidden penalties if the borrower pays the amount early; These are known as prepayment penalties and the borrower should always find out if these penalties apply, or walk away!
4. If the borrower pays only the minimum, the loan will not be repaid. In fact, the loan amount may increase during the term, resulting in a larger balloon payment at the end.
recommendations
Home equity loans can be a great financial management tool when used responsibly. An important benefit of refinancing is the possibility of obtaining an income tax deduction on the payments. A home equity loan vs. a refinance as an option means you can end up with an easy one-time payment while having the security of a fixed rate. Refinancing can be more expensive in the long run with the balloon payment, in many cases being indeterminate at the beginning of the loan!