Should you refinance, take out a home equity loan, or a second mortgage?

Both refinancing and home equity loans let you borrow against the equity you have built up with your home. But the best choice for you may depend on your financial situation and personal goals.

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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. You may also be able to top up your loan amount against your home’s equity and use the borrowed funds to fulfil other goals.

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

A home equity loan is a separate loan that is secured against the equity in your home. Suppose you need a lump sum for an emergency, or plan to carry out some repairs around the house. In this case, you may take out a second mortgage or home equity loan to convert the equity you’ve built up in your home into borrowed cash. This is sometimes the preferred route for homeowners planning to carry out home renovations to increase the value of their home.

What is the difference between a second mortgage and home equity loan?

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.

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.

Refinancing, on the other hand, replaces your existing mortgage with a new loan, typically at better terms, such as a lower interest rate. It doesn’t involve adding a second loan; instead, it restructures your original one.

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.

As refinancing typically replaces one mortgage loan with another, you’ll continue to make structured monthly repayments that gradually reduce both the principal and interest. This can offer a more predictable repayment schedule compared to the flexibility of an equity line of credit.

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.

Deciding between refinancing and a home equity loan depends on your financial goals, current mortgage terms, and how you plan to use the funds. The following points could help you determine which option might be better for your needs:

Consider your financial goals

• Lower monthly payments: If your primary goal is to reduce monthly repayments or secure a lower interest rate, refinancing may be a better fit.
• Accessing funds for specific needs: Both home equity loans and cash-out refinancing allow you to borrow a lump sum against your home’s equity. However, a cash-out refinance, you take out a new mortgage for an amount that’s higher than your previous mortgage balance. A home equity loan allows you to take out a separate loan on top of your existing loan, leaving the original terms of the loan intact. You can also get access to a line of credit with a home equity loan.

Your current mortgage terms

• If your current mortgage already has a competitive interest rate, a home equity loan lets you tap into your equity without losing your existing loan terms.
• Refinancing can help you transition from a fixed-rate to a variable-rate mortgage or secure features better aligned with your financial goals.

Repayment flexibility

• Refinancing typically provides a structured monthly repayment schedule that combines principal and interest, offering predictability and stability.
• A home equity loan may offer more flexible payment options, particularly if you choose a line of credit. This allows you to access funds in smaller instalments and may enable interest-only repayments during the initial drawdown period, helping you manage cash flow more effectively. However, after the drawdown period ends, you’ll need to start repaying both principal and interest, which could lead to significantly higher repayments in the future. Proper financial planning is essential to avoid repayment challenges later.

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.