Homeowners seeking to use equity in their homes to pay off debt or fund home improvements can borrow money against their home by taking out a home equity loan or a cash-out refinance mortgage. A home equity loan occupies the second lien position behind the original mortgage, whereas a cash-out refinance mortgage replaces the original mortgage and provides the borrower with additional cash from the home's equity.
Banks generally charge higher interest rates for cash-out refinance loans than for straight refinancing that just involves paying off the first mortgage. Mortgage rates are driven by the yields offered in 10-year Treasury bonds and rise and fall in conjunction with these debt instruments. Home equity loans are typically based upon the U.S. prime rate. Long-term home equity loans tend to have higher rates than mortgages because banks have to compensate for the prime-rate changes, which occur up to eight times per year and therefore could drastically change during the course of a 20- or 30-year loan. Short-term home equity loans lasting five or 10 years may have rates comparable with a cash-out refinance.
Closing costs are comprised of origination fees, taxes, document stamp fees and other factors, which are determined by the size of the loan. A cash-out refinance has much higher closing costs because the loan amount exceeds the amount of a second-lien home equity loan. Second, home equity loans have fewer costs than mortgages because the loans are not usually sold on the secondary market. Firms that buy mortgages require banks to obtain surveys and full appraisals, which, combined, can cost upwards of $600. Banks often write home equity loans using free automated-valuation-model appraisals and do not use surveys.
Mortgage Premium Insurance
Lenders approve only conventional mortgages if the loan amount does not exceed 80 percent of the home's value. Loans that exceed that amount are only possible if the borrower buys private-mortgage-insurance (PMI). PMI protects the lender and investors from some losses associated with loan defaults. Banks that keep home equity loans in-house do not require PMI, even if the combined loan-to-value of the first and second liens exceeds 80 percent of the home's value.
Homeowners can use mortgage refinance calculators to determine the long-term benefit of taking out a cash-out refinance or a home equity loan. People planning on staying in a home for a short period of time often prefer to use a home equity line, which has a revolving credit and requires only interest-only minimum payments. Long-term loans with the lowest rates usually save the homeowner money, but it depends on the size of the loan, the rates and how long the owner plans to keep the home.