Home Equity Loan or a 1st Refinance for Extra Cash?

Whether refinancing a first lien or taking out an equity loan, one of the biggest advantages of owning your home is that you gain equity as you pay down your mortgage over time. You also gain equity if the value of your home increases over the years. So, if you owe $200,000 on a house that is worth $300,000, you have $100,000 of equity you can tap.

You can use your home's equity to help pay for a child's college education, or pay for home renovations, or even pay off higher interest debt. The best news of all is that you can tap that equity in several ways. The most popular options are to do a cash out refinance and to take out a home equity loan. Which is better? It depends upon the circumstances. Let's break both down.

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What is a Home Equity Loan?

A home equity loan works like a second mortgage on your house. So if you have $50,000 of equity in your property, your lender might approve you for a home equity loan for $40k. After you take out the loan, you will receive a check for $40k. That can be used how you like. You will need to pay the money back over time, just like your first mortgage. You will make regular monthly payments at a fixed low interest rate. This will be paid until the equity home loan is paid off in full. Yes, home equity mortgages are extremely popular when interest rates trend upward. When a person already has a rate below market level then an equity loan or credit line becomes very appealing.

What is a Cash Out Refinance?

A cash out refinance is simply replacing your existing first mortgage with another mortgage, usually at a lower interest rate. You can then refinance your mortgage for more than you owe so that you have cash to pay for what you want. If you owe $100,000 on your house and you are able to do a cash out refi for $150,000, you have $50,000 to spend on what you need. You then are paying your lender back on $150,000.

While you need to take care in how you use that money, it can make sense to take on debt in this way; you will probably never be able to borrow cheaper money than what you can on a mortgage. Also, the interest that you pay on your home loan is probably tax deductible. This can save you substantially when you file your taxes.

Note that doing a cash out refinance can take longer than a home equity mortgage. It will require a new appraisal on the property, as well as title searches and underwriting. A home equity loan also requires some checks but there is usually less processing and they close faster.

Pros and Cons

Which option you select will depend upon several considerations:

  • A refinance for extra money usually has the lower interest rate which gives you lower monthly payments. However, refinancing does have its own costs, and you will need to pay 3-6% at closing for various settlement fees.
  • The interest rate on your current mortgage is critical when deciding if you should do a cash out refi. If your interest rate is higher and refinancing will lower your payment by at least $100, you may want to pull the trigger and refinance. You will be able to save enough in a year or two for the settlement costs to be worth it.
  • If you are only saving $50 per month, you may not be saving enough each month for it to make sense. In that case a home equity loan may be the best choice.
  • A home equity loan can be a top priority if you have held your home loan for many years. So, if you made payments on a 30-year mortgage for 20 years, you may be at the point where you are paying more of your mortgage toward principal than interest. So, it could make sense to do an equity mortgage loan.
  • A home equity loan also has lower borrowing costs because you are not refinancing your entire mortgage. You also may be able to avoid most closing costs with this type of loan.

The Main Point

Doing a first refinance for extra money may be your best choice if you can wait a little longer to get the money you need. It also is a great choice if your current interest rate is higher and a refi will save you more than $100 per month on your payment. A home equity loan involves lower closing costs and less underwriting and can be done faster. Both options allow you to write off the interest that you are paying which is very helpful when filing taxes. Whichever you choose, you should be certain that there are good and valid reasons for borrowing money out of your personal residence. Whether you choose a 1st refinance or an equity home loan, you will need to pay all of that money back eventually.

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