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Refinancing vs. a Home-Equity Loan: The Difference

Author: Christopher Jackson

One good thing about owning a home: It's not just a place to live and an investment (a good one, you hope), it also can be a of ready cash, should you need it.

If you're already living in your home – and you have for a few years – two financial terms probably keep popping up: refinancing and home-equity loans. Maybe you know a little about them but not enough to make financial decisions. They're often used in the same sentence, but they're drastically different.

While different, both of these terms have one thing in common: They relate to raising money using your home. Here's a scenario: Ten years ago, when you first purchased your home, interest rates were nearly 6% on your 30-year fixed-rate mortgage. In 2015, you could get a mortgage for around 4%. Two points could knock a couple of hundred dollars off your monthly payment and far more off the total cost of financing your home.

Or consider a second scenario: You already have an outstanding interest rate but you're looking for some extra cash to pay for a new roof or add a deck to your home. That's where a home-equity loan might become attractive. Over time, a combination of paying down your loan and your home appreciating in value produces equity—debt-free value in your home that you can borrow against to raise cash.

Let's look at each of these options in detail.

Refinancing

Refinancing is basically finding a new lender to pay off your old mortgage balance in exchange for a new mortgage at a lower rate. Sometimes your current lender will do a refinance, too.

Two Types. There are two types of refis (mortgage lingo for refinance): the rate and term refinance and the cash-out loan. A rate/term refi doesn't involve money changing hands other than the costs associated with closing. With a cash-out refi, you get some cash back – taking equity from your home in the form of cash. See Cash-Out vs. Rate/Term Mortgage Refinancing Loans for more information.

One good use of that cash is to pay off other debts – credit cards, student loans, medical bills and the like.

Consider the Costs. A lower interest rate that saves you hundreds per month must be a no-brainer, right? Very few financial decisions are cut and dried, and this is no exception. The problem is closing costs. Even on a refinance, these costs are likely to be 1% to 1.5% of your loan amount. If you refinance, you should plan to live in your home for well over a year. In fact, if you can recoup your closing costs through a lower monthly payment within 18 months, it's probably a good idea to do the refi. To read more, see: When (and When Not) to Refinance Your Mortgage.

Home-Equity Loans

Because they are secured by your property, home-equity loans tend to have lower interest rates than personal, unsecured loans. The only hitch: If you default on your home-equity loan, the lender comes after your home.

Two Choices. There are two types of home-equity loans. (Technically they're quite different but we'll lump them together.) A traditional home equity loan is much like a 30-year mortgage. If you're approved, you receive a loan that you pay over the course of a set period with a set interest rate (in most cases). See Home-Equity Loans: What You Need to Know and Home-Equity Loans: The Costs to learn more.

A home equity line of credit (HELOC) is kind of like a credit card tied to the equity in your home. You can borrow as little or as much of that credit line as you want. During the draw period you pay only interest. Once the repayment period kicks in, you pay principal and interest (see Home-Equity Loan vs. HELOC: The Difference).

These types of loans have closing costs and you'll have to submit various documents to prove you qualify. In general, home equity loans have a higher interest rate than traditional mortgages, but that isn't always the case. Also watch for lenders who advertise just an introductory rate. You might see 1.99% for one year, followed by a range of up to nearly 10%. There may also be a minimum amount you have to borrow. (See How HELOCs Can Hurt You to learn more about the disadvantages of these loans.)

Can You Refinance. In fact, you can. As with a traditional mortgage, if you can lower your interest rate, convert from an adjustable-rate loan to one with a fixed rate or avoid a balloon payment – or if you want to extract more cash from your equity – this might make sense for you. Just remember that every time you refinance something, you're paying extra closing costs and you might be extending the loan, making your total interest payments higher.

One Caveat: Your Credit Score

Your ability to borrow in either strategy depends on your credit score. If you're looking to refinance, and your credit score is lower than when you originally purchased your home, refinancing may not be in your best interests. Before going through the process of securing either of these loans, get your three credit scores. (See Top Places to Get a Free Credit Score or Report.) If they aren't above 740, talk with any potential lender about how your score might affect your interest rate.

If you're not planning to stay in your home for a long period of time, a home-equity loan might be the better choice since the closing costs are less than a refi.

The Bottom Line

Refinancing and home equity loans have downsides, of course. If you're refinancing, try not to take on another 30-year loan. Instead of putting the money you save into your pocket, opt for a shorter duration loan – maybe a 15-year mortgage. Or, take a 30-year loan and make extra payments. Remember that the payment isn't as important as the total amount of money you pay over the life of the loan. Paying on your first loan for 10 years and refinancing for another 30 probably cancels out any positive effect of the refinance. The goal should always be to eliminate debt as quickly as possible.

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