Article Excerpt
If you want to tap into the equity already built in your home, a cash-out refinance or a home equity loan may suit your goals. Learn about the differences.
People throughout Texas rely on mortgages in order to achieve the dream of homeownership. With most home mortgages, you must make a down payment at closing that could be as much as twenty percent of the total purchase price. Some mortgage programs allow you to make a smaller down payment, or even to make no down payment at all.
The difference between the value of your home and the balance of your mortgage loan is known as your “equity.” If your home has a market value of $600,000, for example, and your mortgage has a balance of $350,000, you have $250,000 in equity. Some loan programs allow you to access some of your home’s equity. Two examples are cash-out refinances and home equity loans.
Read on to learn more about these types of loans, how they are similar, and how they are different.
What is a Refinance?
Refinancing entails getting a mortgage loan that replaces your current mortgage loan. The new loan would come with new terms, like a different interest rate and payback period (term).
Homeowners may refinance their homes once they have built up some equity. One option when refinancing is to remove some of your equity and turn it into cash in your pocket. This is a cash-out refinance. A homeowner who is eligible for a government-backed mortgage program like the FHA or VA may be able to obtain a refinance loan through these programs.
At closing, the title company will use the funds from the new loan to pay off the balance of the current mortgage. If the new loan is larger than the balance of the existing mortgage, the homeowner can keep the remainder of the loan.
Suppose the homeowner described above decides to take out a $400,000 refinance loan. Most of the loan funds will go toward paying off the homeowner’s current mortgage balance of $350,000. The homeowner may pocket most of the remaining $50,000, after closing costs, to use for whatever purpose they want. Now that the previous mortgage is paid off, their only obligation is to make payments on the refinance loan.
Read more about the capabilities of refinancing your home.
What is a Home Equity Loan?
Unlike a refinance, a home equity loan does not replace the existing mortgage. Instead, it is a second loan secured by the home, meaning that the homeowner will have to make monthly payments on two loans.
The amount a homeowner can borrow in a home equity loan, as the name suggests, is based on the amount of equity they have in the home. The homeowner in the example above has $250,000 in equity in their home. This does not mean that they can borrow that entire amount. Lenders typically restrict the amount of money they will lend to a percentage of the total equity amount. The percentage varies among lenders.
Photo by Marco Verch Professional Photographer from Flickr [Creative Commons]
The Differences Between Cash-Out Refinancing and Home Equity Loans
Refinance and home equity loans are different in several ways that may be very important to your decision.
First vs. Second Loan
A home with a mortgage serves as security for that loan. Another term for this is “collateral.” If a homeowner stops making payments on their mortgage, the lender may foreclose on the home in order to recover the money owed to them. A home can secure more than one loan, such as when a homeowner has a mortgage and a home equity loan. In that situation, the loans must have a clear hierarchy of priority.
A purchase-money mortgage almost always has the highest priority. It is known as the “first mortgage” or “first loan.” A lender with the highest priority has the superior right to foreclose on the property or to recover money owed to it if a homeowner files for bankruptcy. A second mortgage lender may not be able to foreclose if the first mortgage is still in place.
Since a refinance loan pays off the previous mortgage, it becomes the new first mortgage with the highest priority. A home equity loan may exist alongside another mortgage loan, which means it has secondary priority.
Better Interest Rates for Refinance Loans
Issues like priority can affect the terms of a loan. A second mortgage is considered a greater risk than a first mortgage since the right to foreclose is not as straightforward.
Refinance loans are not very risky since they can take the first mortgage spot. That low-risk status often translates into lower interest rates. Home equity loans bring greater risks for lenders, so they may charge higher interest rates to account for that.
Similarities Between Cash-Out Refinancing vs Home Equity Loans
Refinances and home equity loans can help accomplish some of the same goals. Here are some ways in which they’re similar.
Factors Considered by Lenders
Lenders usually consider the same factors when deciding what terms to offer for new mortgage loans, refinances, and home equity loans. These factors may include:
Credit score
Credit history
Debt-to-income ratio (DTI)
Loan-to-value ratio (LTV)
Quick Turnaround
Both refinance loans and home equity loans can put cash in a homeowner’s hands fairly quickly. In many cases, a homeowner can access the money within a few days of closing.
Limit on Amounts of Home Equity
Both types of loans have limits on how much a homeowner can borrow. Refinance loans usually require a homeowner to maintain a certain percentage of equity. If the hypothetical homeowner mentioned above, whose house is valued at $600,000, wants a conventional refinance loan, they may have to retain 20% equity in the home. The maximum amount they could borrow would be $480,000. Some loan programs may allow a homeowner to borrow more money. VA loans may allow a homeowner to borrow 100% of the home’s value.
Home equity lenders also tend not to allow homeowners to borrow the full amount of their equity. They may limit the total loan amount, including any other mortgages, to somewhere between 75% and 90% of the home’s value. In our example of the homeowner with the $600,000 home, their total indebtedness may therefore be limited to between $450,000 and $540,000. Since the homeowner already has a $350,000 mortgage, the maximum amount they could borrow from a home equity lender might be between $100,000 and $190,000.
Make Fast Use of your Equity with an Experienced Mortgage Lender
You’ve worked hard to build equity in your home. You deserve a mortgage lender with your best interests in mind. Get attentive care from one of The Wood Group of Fairway’s many loan officers equipped to make your experience easier than you thought possible.
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