Should you get a home equity loan when refinancing?

If you are applying for a mortgage refinance you may want to take time to review all of your finances in order to maximize the benefits of refinancing. One possibility when refinancing a mortgage on your home is to consider the benefits of a home equity loan or a home equity line of credit in addition to your first mortgage. If you have debts to pay, home improvements to make or college tuition to cough up, borrowing from your home equity could be a smart move.

How hard is it to qualify for a home equity loan?

Tightened credit standards and reduced home values have made lenders slower to approve home equity loans for some borrowers. You will need an appraisal to prove the home is sufficiently valuable to repay both the first mortgage and the home equity loan in the event the property is sold.

In addition to proving your home's value, you need to prove your ability to repay the home loan by demonstrating income, assets and a good credit score. Most lenders reserve their lowest interest rates for borrowers with a credit score of 720 or above.

How much can you borrow on a home equity loan?

 Generally, lenders will allow homeowners to borrow up to a maximum of 90 percent or sometimes 95 percent of the home's value in combined mortgages. For example, if your home is worth $100,000 and you owe $75,000 on your existing mortgage, you have $25,000 in equity. A lender would likely allow no more than $90,000 in debt on the home, so you could be able to borrow another $15,000.

Benefits of a home equity loan

Home equity loans can be one of the most economical ways to borrow money, since the interest rates are generally lower than on a first mortgage and significantly lower than credit card interest rates. In addition, the interest paid on a home equity loan is often tax deductible, unlike credit card payments.

Avoiding private mortgage insurance (PMI)

Borrowing more than 80 percent of your home equity on one home loan requires the lender to charge for private mortgage insurance (PMI), which provides insurance to the lender in case of a loan default. One way to avoid paying PMI is to have two home loans on the same property: a mortgage and a home equity loan or line of credit.

Home equity loan or home equity line of credit?

Homeowners can choose between two types of home equity loans.

  • Home equity loan. This is a fixed-rate loan for a specific time period, with the money available as a lump sum. This type of loan is best if you are looking for debt consolidation benefits or if you have a planned home improvement project with a budget. A home equity loan is essentially a second mortgage on your property which usually must be paid within ten to 15 years.
  • Home equity line of credit. A home equity line of credit is an open-ended home loan with a variable interest rate, paid only on the portion of the loan that you actually use. As you make payments on a home equity line of credit you can then access the principal again. If you have no immediate need of funds but want the flexibility of easy access to borrowed money, a home equity line of credit could be a good option. Some homeowners choose to have one to function as an emergency fund or to have available for future needs such as tuition payments.

Reducing home equity loan costs

Applying for a home equity loan or line at the same time as a mortgage refinance can be advantageous since the same appraisal and credit check can be used for both loans. Home equity loans do not require the same level of closing costs and fees as a refinance.

Disadvantages of home equity loans

While the benefits of debt consolidation or having access to an emergency fund are important, you should also be aware of the primary danger of home equity loans: they are secured by your home, so if they are not repaid, you could lose your home. Home equity loans are generally shorter-term home loans than first mortgages, so be aware of the deadline to pay the loan in full.

If you are disciplined in your spending, you are best prepared to use the equity in your home wisely, for long-term financial planning or for valuable home improvements, and to repay the home loan on time.