Both refinancing and home equity loans provide you with a way to borrow against the equity you have built up with your home. When you choose to refinance, your old mortgage is replaced by a new one, often at a lower rate of interest. On the other hand, a home equity loan is a separate loan that gives you cash that is secured against the equity in your home.
If you are planning to stay in your home for at least a couple of years, you may consider refinancing to a lower rate to reduce your monthly repayments. You can also refinance to top up your loan amount against your home’s equity.
Suppose you need a lump sum for an emergency or plan to carry out some repairs. In this case, you may take out a second mortgage or home equity loan to convert the equity you’ve built up in your home into borrowed cash. This is sometimes the preferred route for homeowners planning to carry out home renovations to increase the value of their home.
What is the difference between a second mortgage and home equity loan?
To make things clearer, a second mortgage and home equity loan often refer to the same thing. A home equity loan is also called a second mortgage because it follows the first mortgage that was obtained to purchase the home.
Here are four points to help you understand a home equity loan better and how it differs from a refinanced home loan.
1. A home equity loan can be a lump sum or in the form of a line of credit
There are two types of home equity loans: a traditional home equity loan where you borrow a lump sum and a home equity line of credit.
A home equity line of credit can be understood as a credit card that’s tied to the equity in your home. This means you can borrow money up to the maximum credit limit approved by the lender, as and when you need it, within a predetermined period known as the drawdown period.
The advantage of a home equity line of credit is that you can borrow as much money you need within your approved credit limit and you only pay interest on the amount you have borrowed in the drawdown period. But, the credit line ends once the drawdown period ends and you then have to start repaying the principal plus interest.
On the other hand, when you refinance your mortgage, you generally replace your existing mortgage with another principal and interest loan, often at a lower rate of interest.
2. A home equity line of credit loan may have flexible repayment terms
With a home equity line of credit, you may choose to make interest-only repayments or opt to have your interest added to your home loan balance. If you choose the latter, you will reach your approved limit sooner than if you decided to make interest-only payments. Some lenders will also allow multiple repayments, without any fee, giving you more flexibility in managing your funds.
Of course, like any other mortgage product, you still have to pay both principal and interest components of the loan after a set period of time. So, even if you opt for lower minimum monthly repayments initially, repayments will have to be increased eventually. Paying only the minimal amount for most of the term can increase your repayment amount considerably towards the end of the loan term.
3. A home equity line of credit loan may cost more than refinancing in the long term
Taking out a home equity line of credit may offer more flexibility in terms of repayments when compared to a traditional principal and interest home loan.
But the flexibility may cost you extra in terms of a higher interest rate on your drawdowns, when compared to a refinanced home loan.
You may pay a lower interest rate than what is usually charged on a personal loan or credit card debt, as the equity in your property backs your borrowing, but a higher rate of interest than if you refinanced.
4. A home equity loan may require some planning to manage
Refinancing replaces your existing loan with a new mortgage, and you continue making monthly repayments like before to pay down the principal and interest gradually.
However, managing a line of credit requires some additional financial planning. Suppose you are only paying the interest during the drawdown period. In that case, you’d find your monthly repayments jump considerably once the interest-only period is over. It is often a good idea to discuss your requirements with a mortgage broker to understand the risks and pitfalls associated with any mortgage product.
Ultimately, whether you choose to refinance your mortgage or take out a home equity loan will depend on your personal circumstances. In either case, many lenders will only allow you to borrow up to 80 per cent of your home’s value across all your loans unless you are considered a low-risk professional, like a doctor or allied healthcare practitioner. You may consult a broker to find out about special offers and discounts for your profession.