There are different private lending options for you to consider. It’s essential to know the differences between refinancing and home equity loans. There’s flexibility with the home equity loan and accessibility for borrowers who want to leverage the value they’ve built up in their property. Comparing a home equity loan versus refinancing demands careful thought.
Defining Home Equity Loans and Refinancing
A home equity loan offers a stable and predictable product for accessing and using the equity you’ve built up in your home. Equity is defined as the property’s current market value minus any outstanding mortgage and debt balances. These loans have a fixed repayment schedule and a defined loan term of one year, with the possibility of resigning.
Refinancing is different. This process involves swapping out an existing mortgage for a brand-new one. Potential borrowers need to know that there can be prepayment penalties for breaking a current mortgage contract. People refinance for various reasons, including switching from a variable to a fixed rate or the other way around and getting a lower interest rate.
One of the biggest differences between a home equity loan and refinancing is that a home equity loan often adds a second mortgage on top of the first one. Refinancing replaces a current mortgage with a new one.
There’s only one payment to make with refinancing. A home equity loan requires two.
Benefits of Home Equity Loans
These loans have several advantages, including lower interest rates than credit cards or personal loans. That’s because the loan is secured by property that is used as collateral.
Private lenders offer these loans for various reasons, including home renovations, emergency funds, and debt consolidation.
- They offer flexible payment options, such as interest-only mortgages. This is an excellent way for borrowers with less-than-perfect credit to choose a payment option that meets their financial situation.
- One of these private home equity loans involves a streamlined process. Private lenders don’t emphasize credit scores, which are metrics for traditional banks.
One of the other benefits of home equity loans from a private lender is the faster application process. These lenders are also able to customize the loan terms. That’s not always the case with larger banks or financial institutions because they have more extensive administrations.
Impact on Credit Score and Debt-to-Income Ratio
Both of these products can affect the financial snapshot lenders use to decide your creditworthiness.
Credit Scores and The Home Equity Loan
Applying for one of these loans can cause a small temporary drop in your credit score because the process involves a hard inquiry into your credit report.
Traditional lenders also consider the debt-to-income (DTI) ratio. The lower this ratio, the better your chances of getting good terms. This metric compares an applicant’s gross monthly income to their monthly debt payments. While it doesn’t directly affect your credit score, a high DTI can make you look like a higher risk to potential lenders.
Credit Scores and Refinancing
Equifax also reports that refinancing a mortgage impacts your credit score. A refinance can appear on a credit score as a brand-new loan. Because you need to close an existing mortgage to open a new one, this can negatively affect your credit score. This is especially true if the original mortgage is your oldest account.
Refinancing your mortgage can also affect your debt-to-income (DTI) ratio for a more traditional bank loan. Applicants who extend the loan term or sign on for a lower rate can make lower monthly payments. That can show up as a decrease in your debt obligations and improve your DTI.
Choosing the Right Option for Your Financial Goals
Understanding your financial goals can help you choose between a home equity loan and refinancing. Here are five scenarios that can help you make a decision.
You Need a Flexible Loan
Private lenders offer flexible and streamlined application processes. However, applying for a traditional bank refinance requires documentation, including T4 slips and a steady employment background of at least two years.
A private home equity loan accepts freelance and sole proprietor income, which means there is less of an administrative burden when applying for one of these interest-only loans.
You Need The Funds Quickly
Private lenders will allow you to get the funds quickly, making a home equity loan a sensible alternative to refinancing, especially when you’re looking at an emergency home repair or a time-sensitive project.
You Dont Want To Lose A Good Mortgage Rate
You might have a reasonable rate on an existing mortgage, and refinancing would put you in a position with a higher one. A private home equity loan allows you to keep the terms of your original mortgage intact.
You Want To Avoid Large Refinancing Costs
Refinancing through a traditional institution involves applying title insurance and appraisal fees. Remember that you’ll probably need to break an existing mortgage to refinance, which can drive these costs up.
A home equity loan is considered a second mortgage, so the original loan terms are preserved, and there are no penalties.
Your Credit Score Isn’t Where You’d Like It To Be
Private lenders who supply home equity loans look at the equity you’ve built on your property rather than your credit score.
The loan-to-value (LTV) ratio is the metric private lenders use whether you’re looking to get a home equity loan or refinance through one.
Here’s how one of those LTVs would work for someone with a credit score under 560. The LTV ratio is a percentage representing the property’s value owed in mortgages. It’s considered the old loan plus any new loan divided by the property’s appraised value.
So, a homeowner has a home worth a million dollars with a first mortgage of $500,000. If they are looking for a second mortgage of $250,000, the LTV ratio for the requested mortgage can be up to 75% of the property’s value.
LTV = Total Loan Amounts / Appraised Value of the Property.
Ultimately, making the right decision means understanding some key differences between refinancing and a home equity loan. Remember that a home equity loan adds a second mortgage on top of a first one, and refinancing replaces the primary existing mortgage with a brand-new product.
