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Should You Refinance Your Mortgage or Get a Home Equity Loan?

Should You Refinance Your Mortgage or Get a Home Equity Loan?

  • Options for Borrowers to Access the Equity in a Property
  • A cash-out refinance and debt consolidation refinance are ways for borrowers to access the equity in their property. A home equity loan or line of credit are other options for borrowers to take money out of their property without refinancing their current mortgage.  There are multiple factors borrowers should consider when deciding between refinancing their mortgage or taking out a smaller home equity loan or line of credit.  In many cases a home equity loan or line of credit credit can save the borrower on upfront closing costs and total interest expense over the life of the loan.  Below, we outline the positives and negatives for each home financing approach and review examples that demonstrate when each option makes financial sense for borrowers.

    There are pros and cons to both financing options and the right answer depends on the borrower’s financial situation and objectives.  The key factors that determine if it makes sense to refinance or use a home equity loan or line of credit are the length of time you have been paying down your existing mortgage as, your mortgage rate and the terms for and home equity loan or line of credit.  Closing costs are typically lower with a home equity loan or line of credit which is an added benefit but that should not be the determining factor in deciding what financing option is right for you.

    In many situations it it makes more financial sense to obtain a home equity loan or line of credit instead of refinancing your mortgage.  Unless you are able to reduce your mortgage rate and loan term for by refinancing, it typically makes more sense for borrowers to select a home equity loan or line of credit, as long as you can access the amount of money you need.

    This is because by refinancing your existing mortgage, unless you reduce the term of the new mortgage, you are basically starting over paying back the original loan, which costs you thousands of dollars more in interest expense. For example, if you are ten years into a $200,000 30 year mortgage and you refinance with a new $200,000 30 year loan you have essentially converted your original 30 year loan into a 40 year mortgage, which means you pay significantly more in total interest over the life of the loan. The longer your mortgage, the more interest expense you pay.

    By comparison, the loan amount for a home equity loan or home equity line of credit (HELOC) is smaller than a new mortgage plus your loan term may be shorter. For example you may be able to arrange a 10 to 20 year home equity loan. The smaller loan amount and shorter loan term combine to significantly reduce how much total interest you pay as compared to refinancing your mortgage.

    While a home equity loan or HELOC offer significant financial benefits as compared to refinancing, there are several situations when refinancing is the better option.  First, if you are able to reduce your mortgage rate when you refinance that can lower your monthly payment and save you a significant amount of money.  If you can lower your rate by at least .750% then it usually makes sense to refinance.

  • CalculatorUse our CASH-OUT REFINANCE CALCULATOR to determine if it makes sense to refinance your mortgage or use a home equity loan
  • Second, if you can shorten the length of your mortgage then refinancing is an attractive alternative. Reducing your mortgage length, such as refinancing a 30 year loan with a 20 year loan, enables you to avoid extending the term of your loan and lowers your total interest expense. Another reason why a refinance is preferred to a home equity loan or HELOC is if you want to change mortgage programs. For example, if you have an adjustable rate mortgage, you may want to refinance into a fixed rate loan for greater certainty.

    The final case when refinancing is preferred over a home equity loan is if you want to take a significant amount of money out of your home. A home equity loan or HELOC may apply a maximum loan amount and you may be able to access more equity in your home with a cash-out refinance. In short, there are multiple cases when a refinance is a better financing option than a home equity loan, depending on your current mortgage terms and financial objectives.

  • Example Comparing a Refinance to a Home Equity Loan
  • The examples below show different scenarios for comparing refinancing to a home equity loan.  The examples compare the mortgage payment, total interest expense and total debt payments for multiple refinance and home equity loan scenarios, including different mortgage rates and loan terms.

    As demonstrated by Example #1, when comparing a refinancing to keeping your original mortgage and using a home equity loan there may be a trade-off between having a higher monthly payment for a set number of years (10 to 15 years for a home equity loan) and paying less in total interest over the life of the mortgage.  If you can afford the higher monthly payment for a set number of years it typically makes more sense and saves you money in total interest expense over the long term to keep your current mortgage in place and obtain a home equity loan or line of credit.

    In an ideal scenario presented in Example #2, you are able to reduce your mortgage rate and term by refinancing, enabling you to lower your monthly mortgage payment, reduce your total interest expense over the life of the mortgage and access the equity in your property. Otherwise, if you can afford the higher monthly payment for a set number of years it typically makes more sense and saves you money in total interest expense over the long term to keep your current mortgage in place and obtain a home equity loan or line of credit.

    Review the detailed examples below to understand the financing option that best meets your personal and financial objectives.

  • Example 1: Comparing a Home Equity Loan to a Refinance with No Reduction in Interest Rate or Term
  • The example below demonstrates how a home equity loan can save you hundreds of thousands of dollars in total interest expense as compared to a refinancing.  In this example the borrower is ten years into the original $300,000 mortgage and wants to access $50,000 in property equity for a major purchase.  The example compares two scenarios for accessing equity in a property: a home equity loan and a cash-out refinance.  In the refinance scenario, the borrower does not reduce his or her term or mortgage rate by refinancing and replaces the original 30 year $300,000 mortgage with a new 30 year $300,000 loan.

    • Scenario 1: The borrower uses a 15 year $50,000 home equity loan and keeps the original mortgage in place
    • Scenario 2: The borrower uses a cash-out refinancing to access $50,000

    As demonstrated by this example, because the borrower does not reduce his or her mortgage term or interest rate by refinancing, the cash-out refinance costs the borrower thousands more in total interest expense when you combine the original and new mortgages.  When you add the interest expense from the first ten years of the original mortgage to the new refinanced mortgage, the borrower spends $111,250 more in total interest expense as compared to keeping the original mortgage and taking out a home equity loan.

    This is because the cash-out refinance effectively extends the term of the original mortgage by 10 years (so the borrower makes 10 extra years of mortgage payments in Scenario 2). The total interest expense is greater in the refinancing scenario even though the interest rate on the new mortgage is less than the rate on the home equity loan.

  • Great Mortgage IdeaIf you are unable to reduce your interest rate or term by refinancing then a home equity loan or line of credit usually makes more financial sense

Scenario 1: Original Mortgage
Plus Home Equity Loan

Original
Mortgage
Home Equity Loan Total
Loan Amount $300,000 $50,000
Term 30 years 15 years
Current Principal Balance $244,000 $50,000
Interest Rate 5.00% 6.00%
Monthly Payment $1,610 $422 $2,032
Total Interest Expense $279,600 $25,950 $305,550

Scenario 2: Cash-Out Refinancing
No Reduced Term or Interest Rate

Cash Out
Refinancing
First 10 Years of
Original Mortgage
Total
Loan Amount $300,000
Term 30 years
Current Principal Balance $300,000
Interest Rate 5.00%
Monthly Payment $1,610 $1,610
Total Interest Expense $279,600 $137,200 $416,800
Total Interest Expense Savings / (Cost) ($111,250)
  • Example 2: Comparing a Home Equity Loan to a Refinance with a Reduction in Interest Rate or Term
  • The second example below demonstrates how a refinancing can save you thousands of dollars in total interest expense as compared to keeping your original mortgage and obtaining a home equity loan if you are able to reduce your mortgage rate and shorten your term when you refinance.  In this example the borrower is ten years into the original $300,000 mortgage and wants $50,000 for a major purchase.  This example also compares two scenarios for accessing equity in a property: a home equity loan and a cash-out refinance.  In this example, however, in the refinance scenario the borrower replaces the original 30 year $300,000 mortgage with a 5.00% interest rate with a new 20 year $300,000 mortgage with a 4.00% interest rate.

    • Scenario 1: The borrower uses a 15 year $50,000 home equity loan and keeps the original mortgage in place
    • Scenario 2: The borrower uses a cash-out refinance to access $50,000 and reduces both the interest rate and term of the mortgage

    As demonstrated by this example, because the borrower reduces his or her loan term and mortgage rate, refinancing saves the borrower thousands in total interest expense.  When you add the interest expense from the first ten years of the original mortgage to the new refinanced mortgage, the borrower saves $32,050 in total interest expense as compared to keeping the original mortgage and taking out a home equity loan.

    Because the mortgage term was reduced from 30 years to 20 years, the borrower’s monthly payment increases from $1,610 to $1,818 with the new refinanced mortgage even though the loan amount stayed the same and the mortgage rate decreased.  The shorter the term, the higher the monthly payment but the lower the total interest expense over the life of the mortgage.  Despite the increase, the new monthly mortgage payment of $1,818 is less than the $2,032 combined monthly payment of the original mortgage ($1,610) and the home equity loan ($422).

  • Great Mortgage IdeaIf you are also able to reduce your interest rate and term, refinancing can save you money in total interest expense as compared to a home equity loan

Scenario 1: Original Mortgage
Plus Home Equity Loan

Original
Mortgage
Home Equity Loan Total
Loan Amount $300,000 $50,000
Term 30 years 15 years
Current Principal Balance $244,000 $50,000
Interest Rate 5.00% 6.00%
Monthly Payment $1,610 $422 $2,032
Total Interest Expense $279,600 $25,950 $305,550

Scenario 2: Cash-Out Refinancing
Reduced Term AND Interest Rate

Cash Out
Refinancing
First 10 Years of
Original Mortgage
Total
Loan Amount $300,000
Term 20 years
Current Principal Balance $244,000
Interest Rate 4.00%
Monthly Payment $1,818 $1,818
Total Interest Expense $136,300 $137,200 $273,500
Total Interest Expense Savings / (Cost) $32,050
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    Points: Fees you are willing to pay in order to get a lower interest rate. The number of points refers to the percentage of the loan amount that you would pay. For example, "2 points" means a charge of 2% of the loan amount.
     
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    P & I More Info
    Principal & Interest: A periodic payment, usually paid monthly, that includes the interest charges for the period plus an amount applied to the reduction of the principal balance.
    Mortgage Insurance More Info
    Mortgage Insurance: The monthly cost for a policy that protects the lender in case you’re unable to repay the full amount of the loan. It is typically required for loans that have a loan-to-value ratio between 80% to 100%.
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    Property Tax More Info
    Property Tax: (Also called "Real Estate Tax.") Property taxes are government assessments on real estate property. With mortgage financing, the local, county or state tax assessment on real estate property is considered part of the monthly housing obligation and typically collected and set aside by the lender ...
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    Homeowner Insurance More Info
    Homeowner Insurance: or also commonly called hazard insurance, is the type of property insurance that covers private homes. It is an insurance policy that combines various personal insurance protections, which can include losses occurring to one’s home, its contents, loss of its use, or loss of other personal possessions of the homeowner, as well as liability insurance for accidents that may happen at the home or at the hands of the homeowner within the policy territory.lender ...
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    Points Fees you are willing to pay in order to get a lower interest rate. The number of points refers to the percentage of the loan amount that you would pay. For example, "2 points" means a charge of 2% of the loan amount.
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    Origination Charge: A loan origination charge is a fee charged by the lender for evaluating, processing, and closing the loan.
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    Credit Report Fee: Fee charged to obtain an applicant’s credit history prepared by one or all of the three major credit bureaus. Used by lender to determine the borrower’s creditworthiness.
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    Tax Service Fee: A fee charged by the lender to cover the cost of retaining a tax service agency. These agencies monitor the property tax payments on the property and report the results to the lender.
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    Processing Fee: A processing fee is a charge by the lender for clerical items associated with the loan. Examples of processing include loan set up, organization of loan conditions for underwriting, and preparing required disclosures for the borrower.
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    Underwriting Fee: A fee charged by the lender to verify information on the loan application, authenticate the property’s value, and perform a risk analysis on the overall loan package.
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    FHA Upfront Premium More Info
    FHA Upfront Premium: A fee paid in cash at the close of escrow or more commonly it is financed into the loan. These premiums are pooled together by the FHA and are used to insure the risk of borrower default on FHA loans. FHA upfront premiums are prorated over a five year period, meaning should the homeowner refinance or sell during the first five years of the loan, they are entitled to a partial refund of the FHA upfront premium paid at loan inception.
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    Other fees could be either additional Administrative Fees that a lender charges or it could be a Flat Fee to cover all lender charges such as: (Origination Fees, Points, Underwriting and Processing Fees, Credit Reports and Tax Service Fees)

    The flat fee does not include prepaid items and third party costs such as appraisal fees, recording fees, prepaid interest, property & transfer taxes, homeowners insurance, borrower’s attorney’s fees, private mortgage insurance premiums (if applicable), survey costs, title insurance and related services.

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    Compare Refinance Mortgage Rates as of August 18, 2018
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    Data provided by Informa Research Services. Payments do not include amounts for taxes and insurance premiums. The actual payment obligation will be greater if taxes and insurance are included. Click here for more information on rates and product details.
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