How do second mortgages and home equity loans differ from refinancing?

Refinancing replaces your current home loan with a new loan that can offer more advantageous terms and features. It involves paying off your existing loan and obtaining a new loan, either through negotiation with your current lender or switching to a different loan provider.

Many homeowners choose to refinance for various reasons, each offering potential benefits:

• Reducing mortgage payments
• Lowering interest rates
• Transitioning from a fixed-rate to a variable rate
• Withdrawing equity
• Consolidating multiple loans

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.

Refinancing replaces your existing mortgage with a new one, while a home equity loan or second mortgage provides borrowers with a new loan in addition to their existing mortgage.

Refinancing and home equity loans or second mortgages are actually quite similar. Both allow you to borrow against the equity in your mortgaged property. You can access a lump sum of cash through both methods. However, neither option will allow you to borrow 100% of your equity - most lenders will require you to leave at least 20% equity in your home.

Below 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 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.

The lump sum option lets you use the equity that you’ve built up in your home as security to borrow money. This lump sum has to be repaid with interest.

A home equity line of credit works similarly to 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 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.

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, your repayments will have to be increased eventually. Paying only the minimum amount for most of the term can increase your repayment amount considerably towards the end of the loan term.

3. A home equity 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 on a home equity line of credit 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 and topped up your mortgage.

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 may require some additional financial planning. For example, 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% 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.