Home Equity Loan vs Refinance - The Pros and Cons

Let us first start by defining what a Home equity loan is and what refinance means and then look at the pros and the cons.

Home Equity

Home equity loans are used when you want to borrow a set amount against the increase in value of you home over the amount you owe. A home equity loan is most commonly held in a second position lien (second trust deed), this is because the home owner usually has an existing loan. If however, the original mortgage had been repaid then the home equity loan amount would be secured against the property as a first position lien. A home equity loan then can be either a first mortgage or a second mortgage!

Refinance

The concept of refinancing your mortgage is fairly simple - You replace your primary mortgage for an amount higher than the outstanding balance. So it differs substantially from a home equity loan as it is akin to taking out a completely new mortgage!

Equity Pros

1. It is common to be able to borrow up to 100% or more of the value of the home, less any outstanding debts or mortgages. There are also lenders that will lend up to 125% in special circumstances and these are referred to as 'over-equity' loans.

2. In the United States, under certain circumstances, it is often possible to deduct home equity loan interest on one's 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 the loans.

Equity Cons

1. A home equity loan creates a lien against the borrower's house, and reduces actual home equity. This means that the loan to equity ratio, if further borrowing is needed, can only improve through rising property prices.

2. Since it is a debt against your own 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 history, and a reasonable loan-to-value ratio. The reason for this is simple. If the home owner gets into financial difficulties and since most equity loans have a second lien then in default situation the primary lien holder gets paid first - the secondary lien holder gets the 'balance' that's left!

Refinance Pros

1. If you refinance your mortgage, you may be able to reduce your current rate.

2. It's most beneficial when rates are lower.

3. It can be attractive to home owners looking to consolidate other high interest debts as the credit score of the borrower is often relied on to a lesser extent than a home equity loan.

Refinancing Cons

1. By doing a 30-year refinance now you reduce your payments but now your house won't be paid off for another 30 years.

2. An often large lump sum is payable at the end of the loan and is referred to as a balloon payment - If you can't make the balloon payment or refinance, you face foreclosure and the loss of your home.

3. There can be hidden penalties if the borrower pays off the amount early - these are known as pre-payment penalties and the borrower should always find out if these penalties apply - or walk away!

4. If the borrower pays the minimum only - the loan will not get repaid. In fact the amount of the loan can increase over the period resulting in a larger balloon payment at the end

Posted in: Equity,Refinance