Home Equity Loans vs. Refinancing – Which is Right for You?

As the Australian housing market experiences notable shifts, understanding financial tools like refinancing and home equity loans is more crucial than ever. With fluctuating interest rates affecting borrowing costs, mortgage payments, and significant changes in property values across various regions, homeowners must stay informed. For instance, combined capital city housing prices have risen by 7.06%, while regional areas have seen similar increases due to ongoing demand and limited supply​.

In this blog, we’ll clarify the differences, pros, and cons of refinancing and home equity loans, outline how to choose which option might be better for your specific financial situation, and provide clear insights to help you make an informed decision about leveraging your home’s equity.

At Unconditional Finance, we prioritise personalised service and expert guidance, ensuring that every client receives tailored solutions to meet their financial goals. Our team of experienced finance brokers is dedicated to helping you explore the complexities of the Australian housing market, making it easier to make informed decisions about leveraging your home’s equity.

Understanding the Difference: Refinancing vs. Home Equity Loans

Refinancing

Refinancing involves getting a new mortgage, usually at a lower interest rate, to replace your current one. This move can help reduce your monthly payments, change the loan term, or consolidate debt into a single payment.

Example Scenario:

Sarah, a homeowner in Sydney, has a 30-year mortgage with an interest rate of 4.5%. Over the years, interest rates have dropped, and she now has the opportunity to refinance her mortgage at a 3.2% rate. By refinancing, Sarah lowers her monthly payments and decides to switch to a 15-year term, which will help her pay off her mortgage faster and save on interest in the long run. Refinancing also allows her to consolidate a high-interest personal loan into her mortgage, simplifying her finances.

Home Equity Loan

A home equity loan lets you borrow money based on your home’s value, giving you a lump sum for projects like home repairs or paying off debts. These loans usually have fixed interest rates and a clear repayment plan, making them easy to understand and manage.

Example Scenario:

John and Lisa, homeowners in Melbourne, have built significant equity in their homes over the years. They decide to take out a home equity loan to fund major renovations. With property prices in Melbourne rising by approximately 6.7% over the past year​, they leverage their increased equity to secure a loan with a fixed interest rate, ensuring stable and manageable monthly payments.

Pros and Cons of Home Equity Loans

Home equity loans are great for homeowners who need a large amount of cash for major expenses. However, it’s important to consider both the pros and the cons.

Pros of Home Equity Loans

1. Access to Cash for Various Purposes: Home equity loans give you a single large amount of money you can use for anything, such as fixing up your house or paying off high-interest credit cards. For instance, if you need $50,000 for a major home renovation, a home equity loan lets you get that amount upfront, helping you start and finish your project without financial stress.

2. Fixed Interest Rates: These loans typically come with fixed interest rates, offering predictable monthly payments throughout the loan term. For example, suppose you secure a home equity loan at a fixed rate of 4%. This rate will remain constant throughout the repayment period, making budgeting easier.

3. Potential Tax Benefits: Interest paid on home equity loans might be tax-deductible, depending on how you use the money and current tax laws. For example, if you use the loan for major home improvements, you can deduct the interest on your taxes, which reduces your overall tax bill.

4. Lower Interest Rates: Compared to other types of loans, home equity loans generally offer lower interest rates as your home secures them. For example, a home equity loan might have an interest rate of 5%, whereas a personal loan could have a rate of 10% or higher, making the home equity loan a more affordable borrowing option.

5. Large Borrowing Amounts: You can borrow a substantial amount, depending on the equity in your home and your creditworthiness. For example, if your home is worth $500,000 and you have $300,000 in equity, you can borrow up to 85% of your equity, giving you access to $255,000.

6. Flexible Use of Funds: There are no restrictions on how to use the money, giving you the flexibility to meet various financial needs. For example, you could use part of the loan for home improvements, consolidating high-interest credit card debt, and medical expenses.

Cons of Home Equity Loans

1. Risk of Losing Home if Unable to Repay: If you can’t repay the loan, you might lose your home since it’s used as collateral. For example, if you lose your job and can’t make the loan payments, you risk foreclosure, which could lead to serious financial problems.

2. Additional Monthly Payments: A home equity loan means an extra monthly payment, which can stretch your budget thin. For example, if your mortgage payment is $1,500 and your home equity loan payment is $500, your monthly payment becomes $2,000, which might be hard to manage.

3. Limited Loan Amount Based on Home Equity: The amount you can borrow is limited to the equity you have in your home, which may need to be increased for your needs. For example, if you only have $50,000 in equity but need $75,000, you might have to look for additional financing options to cover the shortfall.

4. Closing Costs: These loans often include closing costs and fees, which can increase your overall expenses. For example, on a $100,000 loan, you might have to pay up to $5,000 in closing costs, which can increase the total cost of borrowing.

5. Stricter Qualification Requirements: Lenders typically have stringent qualification criteria, including good credit scores and sufficient home equity. For example, if your credit score is below 700 or your equity is less than 20%, you might face higher interest rates or even be denied the loan.

6. Potential for Negative Equity: If property values drop, you could owe more than your home is worth, known as negative equity. For instance, if the housing market crashes and your home value falls from $500,000 to $400,000, but you still owe $450,000, you’ll be in negative equity, making refinancing or selling your home difficult.

7. Immediate Repayment: Home equity loans require immediate repayment, unlike some other financial options that might offer deferred payment plans. For example, unlike student loans with deferment options, home equity loans start repayment immediately, which could be a financial burden if not planned for.

Pros and Cons of Refinancing

Refinancing your mortgage is an excellent way to lower your interest rate, change your loan term, or combine multiple debts. However, it’s important to understand the pros and cons to make sure it fits your financial plans.

Pros of Refinancing

1. Lower Interest Rates: Refinancing can get you a lower interest rate, which means smaller monthly payments and less total interest over the loan’s life. For example, lowering your rate from 5% to 3.5% on a $300,000 loan could save thousands in interest.

2. Improved Loan Terms: You can adjust the length of your loan to better match your financial needs, like shortening it to pay off your mortgage faster or lengthening it to reduce your payments. For example, refinancing a 30-year mortgage into a 15-year mortgage helps you pay off your home sooner and save on interest, while a 40-year term lowers monthly payments.

3. Switching Loan Types: Refinancing lets you switch from an adjustable-rate mortgage to a fixed-rate one, giving you more stable payments. For example, if your adjustable rate is set to increase, switching to a fixed rate can lock in a low rate and protect you from future increases.

4. Debt Consolidation: You can consolidate high-interest debts into your mortgage, simplifying your payments and lowering your interest costs. For example, by consolidating a $20,000 credit card debt at 18% interest into your mortgage at 3.5% interest, you can significantly reduce your monthly payments and total interest paid.

5. Access to Home Equity: Cash-out refinancing lets you take out a new mortgage for more than you owe and pocket the difference, similar to a home equity loan. For example, if you owe $150,000 on your mortgage and refinance for $200,000, you can receive $50,000 in cash for home improvements or other expenses.

Cons of Refinancing

1. Closing Costs: Refinancing can be expensive, with closing fees that range from 2% to 5% of the loan amount. For example, on a $200,000 refinance, you pay between $4,000 and $10,000 in closing costs, which could reduce the benefits of a lower interest rate.
2. Extended Loan Term: If you extend the length of your mortgage, you may pay more interest over time, even if your monthly payments are lower. For example, refinancing a 20-year mortgage into a new 30-year mortgage lowers monthly payments but could result in paying more interest over the extended term.
3. Qualification Requirements: Similar to home equity loans, refinancing requires good credit and sufficient home equity. For example, if your credit score has declined since you took out your original mortgage, you might not qualify for the best rates or be denied altogether.
4. Potential for Higher Interest Rates: If you extend your loan term, the total interest paid over the loan life could be higher, even with a lower interest rate. For example, lower monthly payments come with a higher total interest paid over a longer period, making the loan more expensive in the long run.
5. Risk of Foreclosure: Just like with home equity loans, you risk losing your home if you can’t make the payments. For example, refinancing can provide financial relief, but missing mortgage payments could lead to foreclosure if your financial situation worsens.

How to Choose Which is Better: Refinance or Home Equity Loan

When choosing between a home equity loan and refinancing, consider which option best fits your financial needs and goals.

Current Interest Rates

Compare the current interest rates for refinancing and home equity loans. Refinancing typically offers lower rates, but a home equity loan provides fixed rates, which might be more predictable and stable in the long run.

Purpose of Funds

Determine why you need the money. If you need a large amount for a big, one-time expense like home renovations or debt consolidation, a home equity loan might be better because it gives you a lump sum with fixed payments. Refinancing could be a better option if you want to lower your monthly mortgage payments or pay off your mortgage more quickly.

Loan Amount Needed

Assess how much money you need. A home equity loan is limited to the equity you have built up in your home. At the same time, refinancing can allow you to borrow more, especially with cash-out refinancing.

Repayment Flexibility

Think about how well you can handle monthly payments. Home equity loans add an extra monthly bill, which can strain your budget if not managed carefully. Refinancing, on the other hand, changes your current mortgage payment, which might be easier to manage.

Tax Implications

Consult with a tax advisor to understand the potential tax benefits of each option. Interest on home equity loans may be tax deductible, depending on how the loan proceeds are used, while refinancing might not offer the same benefit.

Qualification Criteria

Evaluate your credit score, income stability, and home equity. Both options require good credit and sufficient equity, but lenders might have different qualification standards for refinancing versus home equity loans.

Conclusion

Choosing between a home equity loan and refinancing your mortgage requires understanding your financial situation and long-term goals. Both options offer valuable benefits but come with their own set of challenges. Home equity loans are ideal for accessing a lump sum for specific needs with predictable payments. At the same time, refinancing can lower your interest rate, adjust your loan term, and consolidate debts.

By checking current interest rates, understanding your financial needs, and talking with financial advisors, you can choose the best option to use your home’s equity. Staying updated on market trends and considering your financial situation will help you make the best decision.

Ready to leverage your home’s equity? Consult with our experts to determine whether a home equity loan or refinancing is your best option. Contact us today!