One good thing about owning a home: Not only is it a place to live and an investment (a good one, you hope), it can also be a source of cash when you need it ..
If you already live in your house – and you have for a few years – two financial terms probably come up: Refinancing and home equity loans. You may know a little about them, but not enough to make financial decisions. They are often used in the same sentence, but they differ drastically.
While both terms have one thing in common: they refer to collecting money through your home. Here’s a scenario: ten years ago, when you first bought your home, interest rates were nearly 6% on your 30-year fixed mortgage. In 2015, you could get a mortgage for around 4%. Two items could knock a few 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 excellent interest rate, but you’re looking for a little more money to pay for a new roof or add a deck to your home. That’s where a home equity loan could become attractive. Over time, a combination of paying off your loan and your property in value creates a debt-free value in your home that you can borrow against.
Let’s look at each of these options in detail.
Refinance
Refinancing is basically finding a new lender to pay your old mortgage balance in exchange for a new mortgage at a lower rate. Sometimes your current lender will refinance as well.
Two types. There are two types of “refis” (mortgage loans for refinancing): the interest and term refinance and the cash-out loan. A rate / term refi does not involve money changing hands, other than the costs associated with taking out the deal. With a cash-out refi, you get some money back – by taking equity from your home in the form of cash. For more information, see Cash-Out vs. Rate / Term Mortgage Refinancing Loans .
A good use of that money is to pay off other debts – credit cards, student loans, medical bills and the like.
Consider the cost. A low interest rate that saves you hundreds per month must be a no-brainer, or? Very few financial decisions are cut and dried, and this is no exception. The problem is closing costs. Even with refinancing, 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 more than 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 that refi. To learn more, read: when (and when not) to refinance your mortgage.
Home equity loan
Because residential real estate loans are secured by your property, they tend to have lower interest rates than personal, unsecured loans. The only hook: If you fall back on your house loan, the lender comes after your house.
Two options. There are two types of home equity loans. (Technically, they are quite different, but we will put them together.) A traditional home equity loan is similar to a 30-year mortgage. If you are approved, you will receive a loan that you pay within a set period of time with a set interest rate (in most cases). See Home Equity Loans: What You Need to Know and Home Equity Loans: The Cost , to learn more.
A home equity line of credit (HELOC) is something like a credit card tied to the equity in your home. You can borrow as little or as much as you want from this line of credit. During the drawing period you only pay interest. Once the repayment period begins, pay principal and interest (see home equity loan vs. HELOC: The Difference ).
These types of loans have closing costs and you will need to submit various documents to prove you qualify. Generally, home loans have a higher interest rate than conventional mortgages, but this is not always the case. Also watch out for lenders that only advertise an introductory rate. You may have a one-year 1. See 99% followed by a range up to almost 10%. There may also be a minimum amount you need to borrow. (See How HELOCs can hurt you to learn more about the downside 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 pull more cash out of your equity – this might make sense for you. Remember that every time you refinance something, you pay additional closing costs and you could extend the loan, making your total interest payments higher.
One Caveat: Your Credit Score
Your ability to borrow in both strategies depends on your credit score. If you are looking to refinance, and your credit score is lower than when you originally purchased your home, refinancing may not be in your best interest. Before you go through the process of securing one of these loans, get your three credit scores. (See top places to get a free credit score or report.) If they are not above 740, talk to a potential lender about how your score might affect your interest rate.
If you don’t plan to stay in your home for an extended period of time, a home equity loan may be a better choice because the closing costs are less than a refi.
The Bottom Line
Refinancing and home equity loans have drawbacks, of course. If you refinance, don’t try to take out another 30-year loan. Instead of pocketing the money you save, opt for a shorter-term loan – perhaps a 15-year mortgage. Or take out a 30-year loan and make additional payments.Remember that the payment is not as important as the total amount you pay over the life of the loan. If you pay your first loan for 10 years and refinance for another 30, any positive impact of the refinance will likely be cancelled out. The goal should always be to eliminate debt as soon as possible.