Cash-out mortgage refinance or home equity loan - which is better for you?

Always, always, use our 3-question formula to get a clear picture before you apply for a home equity loan or cash-out mortgage refinance or any other loan:

The 3-question formula 1.  what do you need the loan for? 2.  how much loan do you need? 3.  how are you going to repay the loan?

If you answer these three questions objectively and honestly, you will be able to decide for yourself whether or not you should go ahead to apply for the loan.  Go to 3-question formula for its elaboration.

First mortgage rates traditionally are the lowest rates around. Banks and loan investors feel the most secure with these loans because they have first-lien position (ie first-priority claim) against the property in the event the borrower defaults on the loan.

For example, a borrower defaults on a loan secured by a property worth $100,000 net of sale costs.  The property has a first mortgage with a balance of $90,000 and a second mortgage with a balance of $15,000.  The first mortgage lender can collect $90,000 plus any unpaid interest and foreclosure costs.  The second mortgage lender (in second-lien position) can collect only what is left of the $100,000.

When first mortgage rates are lower than home equity loan rates, it usually makes sense for a borrower to raise cash with a cash-out mortgage refinance. In that process, the customer pays off the first mortgage with a new loan larger than the first mortgage balance, and keeps the excess cash. Hence the loan is called a cash-out mortgage refinance.

But rates don't always behave normally. There may be times when home equity loan rates become lower than first mortgage rates, even though most home equity loans are riskier because they're usually in the second-lien (ie second priority) position.

As for home equity lines of credit, most banks set their rates based on the shortest-term market rate of all, the Wall Street Journal prime rate. It moves in lock step with the fed funds rate.

When the Fed raises short-term interest rates, rates on home equity lines of credit will also go higher for both new and existing borrowers, as home equity lines of credit carry variable interest rates.

But both home equity loans and lines of credit usually come without closing costs, so they can be $2,000 or $3,000 cheaper than first mortgages.

So under what circumstances should you go for an equity loan or line of credit rather than a cash-out mortgage refinance mortgage?

If you plan to pay off your loans in a reasonable amount of time, and if you don't need to borrow much money, you are bette off with home equity loans or home equity lines of credit. That's because banks offer their lowest rates on shorter-term equity loans.

Long-term equity loans tend to have rates that are higher than fixed-rate mortgages, even when the prime rate is low. And, customers who need $75,000, $100,000 or more will usually go for longer loan periods to keep their repayments affordable. Most equity loans have a lifespan of 10 years or 15 years, while many first mortgages last as many as 30 years.

If you took out your first mortgage at an extremely low rate, you should raise the cash you need through a home equity loan or a home equity line of credit. It doesn't make sense to replace your very cheap first mortgage with a new, larger first mortgage (ie a cash-out mortgage refinance) at a higher rate, and pay a couple thousand dollars in closing costs.  For example, if you have a very cheap firt mortgage of $100,000, and you need to raise $20,000 cash, you are better off keeping your firt mortgage and borrowing the $20,000 through a home equity loan or line of credit.

Customers willing to bet the economy will remain weak for a while may want to look first at equity lines of credit. If the Fed doesn't raise rates for a long time, the prime rate will stay low as well.  Then the rates of equity lines of credit will also stay low.

Lines of credit offer more flexibility than first mortgage refinances. Equity line borrowers only pay interest on what they borrow.

Cash-out mortgage refinance customers get all their money up front and have to pay interest on the entire balances of their loans until they're paid off.

Banks agree to waive costs on equity loans and lines of credit because they don't have to perform many of the same closing and underwriting steps required on first mortgages. Many opt for computerized property valuations rather than full appraisals, for instance, and order title searches, but not new title insurance.

These are just guidelines for helping you choose between equity loans and cash-out mortgage refinances. If you conclude that equity loans are better for you, then consider "home equity loan or home equity line of credit - which is right for you?" to make your choice.

The real test is in the math. You can consult a refinance calculator and a home equity loan calculator and figure out which one will save you the most money in the long run. Compare the total amounts you will spend in interest and fees. If you are planning on a cash-out mortgage refinance, make sure that you are refinancing with a low enough rate to justify the fees to refinance. Your loan specialist should be able to help you figure out which one is best for your needs. Look for their sources on this site.

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