Refi or second mortgage: How to best tap into home equity
Comparing refinance and second mortgages
- A second mortgage is an additional loan secured by your home.
- Refinancing replaces your existing mortgage.
- Second mortgages are ideal for smaller loan to be repaid quickly.
- Cash-out refinances are better for larger loans or betting better mortgage rates.
When facing large expenses, such as a major renovation, debt obligation or emergency medical bill, many people look to the equity in their home for help.
If you’ve assessed home equity options and determined that a term loan — a lump sum paid back over a fixed period — is right for you, there are two choices that a mortgage lender can help you with: A cash-out refinance or a second mortgage cash-out.
Although both are effective tools for accessing cash, your financial needs and existing home equity will dictate which option is most suitable.
Second mortgage cash-out
A second mortgage can take two forms: a home equity term loan or a home equity line of credit, which is a revolving credit facility. A second mortgage cash-out is a term installment loan that is separate from your mortgage but still uses your home as collateral. You will be holding two loans, with the second mortgage taking a second lien position, meaning your original mortgage lender has the primary right to your home should you default on the loan.
A second mortgage typically allows you to draw upon up to 80 percent of the equity in your home. It is often used for smaller loan amounts of as little as $10,000, although the upper cap depends on the equity in the home. Loan terms are typically 10 to 20 years with fixed interest rates.
Cash-out refinancing replaces your original mortgage with a new one, so you still retain one loan. After your initial mortgage is paid off, you receive the remaining equity in cash. With a cash-out refinance you can typically borrow up to 90 percent of the equity in the home. As you are taking out a new mortgage, the term will likely be another 15- or 30-year period with a fixed or variable interest rate.
Eligibility for both a cash-out refinance and second mortgage cash-out depends largely on how much equity you have in your home, although a credit score of at least 680 is preferred as well as a debt-to-income ratio of less than 45. How long you have owned the property and any previous bankruptcies or short sales will also influence eligibility, depending on the lender. Interest can be tax deductible for both loan types if the amount is under a certain threshold or you spend the funds on home improvements.
Which is my best option?
If you are satisfied with your existing mortgage, or interest rates have increased since you took it out, making refinancing unattractive, consider a second mortgage cash-out. With closing costs lower than with a refinance — typically 2 percent to 5 percent of the loan amount, or sometimes waived altogether — it can be a prudent decision if you need a smaller loan and prefer to pay it off quickly. The flip side of faster repayment, however, is the need to make higher monthly payments. Furthermore, as the loan is taking a secondary position to your original mortgage and therefore adding more risk for the lender, interest rates are higher than with a cash-out refinance.
If interest rates have fallen since you took out your mortgage, and you would like to refinance the entire loan for better terms, a cash-out refinance may make sense. It also is more suitable for those seeking larger loans of $100,000 or more as the refinanced loan becomes your primary mortgage, and is not a secondary loan.
Remember that with a refinancing you will pay all of the origination and appraisal fees associated with first mortgages, including a higher closing cost of some 3 percent to 6 percent of the loan amount. If the new loan term extends your repayment period, you may have reduced monthly payments. As the primary loan on your home, interest rates will be lower than those of second mortgages as well. Lower monthly payments over a longer term, however, often result in more interest paid over time.
Both cash-out refinancing and second mortgage cash-outs offer distinct cost savings and payment options. Consider how your financial objectives compare to lender rates for cash-out refinancing and second mortgage cash-outs to determine how best to tap into your home equity.