HOME EQUITY LOAN VS. MORTGAGE
Updated: Mar 7, 2022
HOME EQUITY LOAN VS. MORTGAGE
HOW ARE THEY DIFFERENT? WHAT ARE THE PROS AND CONS?
What Is the Difference?
Traditionally, a mortgage loan is used to either purchase or refinance a home. A special type of mortgage called a cash-out refinance may serve those who already own their home and want to pull cash from their equity.
A home equity loan is slightly different. These types of loans are essentially a “second mortgage”. This means that they are not used to buy or refinance a home as mortgage loans are. Traditionally, home equity loans are used only to withdraw equity.
Both of these loan types are secured by your existing home’s value. Low rates and affordable financing are available if and when you need to borrow a large amount of money.
Which loan is right for you? This depends on how your personal finances and current mortgage stand. Keep reading to learn how to decide which loan is right for you!
How Does a Cash-Out Mortgage Work?
If your main goal is to pull equity out of your home using a mortgage, the best loan for you will be a cash-out refinance. This type of loan involves replacing your existing home loan with a new mortgage. The new loan will have a larger balance compared to your existing one, however, the difference is returned to you as a cash-back at closing.
A cash-out refinance is a “primary mortgage”, meaning it is slightly lower risk than a traditional home equity loan. Because of this, cash-out refinance rates typically run a bit lower than home equity loan interest rates.
Although, since you are refinancing the entire loan amount, you will have a bigger loan amount and a higher mortgage payment. Essentially, you will start your loan term over. In the long term, you may end up paying more interest than you would have if you kept your original mortgage.
On the bright side, if your existing mortgage rate is higher than current market rates, a cash-out refinance loan could possibly drop your rate and save you some money over the loan lifetime.
How Does a Home Equity Loan Work?
A home equity loan, also known as an HEL, is a type of “secondary mortgage”. Essentially, this means that you will leave your original home loan in place and take out a secondary, smaller loan as well. This means that you will have two separate monthly mortgage payments, one in each type of loan.
More often than not, it is likely that the two monthly payments combined will equal a larger amount than you’d have with a cash-out refinance. So you may be asking, why would I choose a home equity loan knowing this?
Luckily, there are a couple of good reasons why! The HEL will typically have a shorter loan term, which means that there is a shorter period of time that you will be paying interest. This may save you money in the long term.
Pros & Cons of Home Equity Loan VS Mortgage Refinance
Interest rates for home equity loans run a bit higher than those for cash-out refinances. This is because HELs are riskier for mortgage lenders since they will get paid second in the event of a foreclosure. In other words, HELs are “second liens”.
Although this is true, the differences in rates are typically small. Additionally, the loan amount for a home equity loan is typically smaller than a mortgage refinance, meaning you will be paying interest on a smaller sum of money.
Unrelated to this, both HELs and cash-out refinances are fixed loan rates, meaning your rate and payments are predictable.
No matter which type of loan you choose, it is important to shop around for the best interest rate on your desired loan.
Both loan types can last for up to 30 years, however, home equity loans likely will have terms of 5,10,15, or 20 years. On the other hand, if you want a mortgage refinance, your new loan will likely last 30 years. Terms of 10 to 25 years are available for cash-out refinancing, however, shorter-term loans typically have higher monthly payments. This may be the deciding factor for many borrowers, especially those with a high existing debt-to-income ratio (DTI), or a low monthly cash flow.
Max Loan Amount
The amount of money you are permitted to withdraw from your home depends on your current mortgage balance and the current value of your home. When you choose a cash-out refinance, you will likely have at least 20% of your home’s value untouched. In other words, your new loan can only reach up to 80% of your home’s current value. This loan must also pay off your existing mortgage, meaning your maximum cash-back is equal to 80% of your home's current value minus your current loan balance.
This calculation is similar for home equity loans in that the first and second mortgage combined usually is not permitted to exceed 80% of the home’s current value. However, you are not using the new loan to pay off your existing loan. Essentially, the math works out to be almost the same value, however, some lenders may be more flexible than others and may allow you to borrow up to 85% of your home’s value.
Closing costs are roughly the same with both types of loans, however, your loan amount is smaller with an HEL meaning the total upfront fees are much lower than a mortgage loan.
When to Use Each Type of Loan?
Selecting a cash-out refinance rather than a home equity loan can be a great way to keep your monthly expenses low. This is because you are only paying one mortgage rather than two.
On the other hand, a home equity loan is typically a better choice than a cash-out refinance if your current mortgage is near being paid off, or you have a very low mortgage rate. When choosing an HEL you can tap into your equity without changing the rate on your current loan or extending its term.
What’s the Bottom Line?
For many of the younger readers, or those who are focused on minimizing current outgoings, cash-out refinance may be the right path to take while refinancing. However, those who can afford to take a more strategic approach in the present while focusing on the long term gain, they may choose a home equity loan. Whichever category you relate to, it is very important to shop around for a lender that is flexible and can work with your individual circumstances.
If you're not sure which type of mortgage is best for you, we strongly advise you to connect with us as your mortgage lender! As a loan advisor, we can help you compare loan amounts, interest rates, and long-term costs to find the best loan for you! Click here to read more about the Loan Process!
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Warden, P. (2021, October 6). New mortgage proposed for low-income, first-time homebuyers. Mortgage Rates, Mortgage News and Strategy : The Mortgage Reports. Retrieved October 22, 2021, from https://themortgagereports.com/85588/new-mortgage-proposed-for-low-income-first-time-homebuyers.