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Homeownership can be expensive, but building equity in a property also opens up new opportunities. If you need to borrow money in the future, or you want to change your original mortgage terms, you have options. But whether you should refinance or get a second mortgage depends on your financial goals, budget and how long you'll live in the home, among other factors. Here's how to determine the best choice for you.
What Is a Mortgage Refinance?
When you refinance a mortgage, you're taking out a new loan and using it to repay and replace your previous one. The new mortgage will typically have a different principal amount and interest rate.
You might choose to refinance your loan to nab a lower interest rate, change your mortgage terms or access the equity you've built up in the house.
The process of refinancing is similar to taking out your first mortgage: You'll submit a loan application, lenders will review your credit and finances, the home will be appraised and you'll be expected to pay closing costs. (Some lenders offer loans with no closing costs, though the trade-off may be a higher interest rate.)
There are a few types of refinancing options. Two of the most common are:
- Rate-and-term refinance: This replaces your prior mortgage with a new one to secure a lower interest rate or a longer or shorter term. A lower interest rate or longer loan term typically means lower monthly payments. If you shorten your mortgage term, you'll have higher monthly payments but pay less in overall interest.
- Cash-out refinance: This entails taking out a new mortgage for more than what you owe on your home and keeping the difference. This allows you to tap your home's equity for expenses such as home renovations, debt consolidation or medical bills. The amount that exceeds what you owed on your original mortgage is added to your new mortgage principal. The new loan's terms could be different, so your monthly payment might change.
Pros and Cons of Mortgage Refinancing
- If market conditions have changed since you bought your home, or your credit has improved significantly, you might be able to refinance for a lower interest rate and lower your monthly payment.
- If you can handle a larger monthly payment, you could refinance your mortgage loan to one with a shorter term. This enables you to pay off the loan faster and reduces how much interest you'll pay over the life of the loan.
- You can switch from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage so your rate and payment stay the same for the life of the loan. While the monthly payment may be higher initially, it provides more certainty.
- A cash-out refinance allows you to tap into your home's equity to cover major expenses such as home repairs or remodeling. It can provide a lower interest rate than many other borrowing options.
- Since your old mortgage is rolled into a new one, you'll still only have one monthly payment.
- Just like a first mortgage, you'll likely pay closing costs on your refinanced mortgage. These can range from 2% to 6% of the new loan amount and may outweigh savings of a lower interest rate.
- Refinancing means paying off your first loan—but some mortgages come with prepayment penalties. This fee can negate the financial benefits of refinancing.
- If you plan to move in the next few years, you may not have enough time to break even from the costs of refinancing.
- You may not be eligible for refinancing, or find a better loan than your current one, if your credit score has fallen or your home's market value has decreased.
- If you switch to a loan with a longer term, you'll likely pay more in interest in the long run.
What Is a Second Mortgage?
Another way to utilize the equity in your home is to take out a second mortgage. This keeps your original loan in place and adds a new one that also uses your home as collateral. A second mortgage doesn't change your original mortgage; it adds on additional debt you can tap to borrow money (though lenders restrict how much equity you can take out).
Two of the most common types of second mortgages are:
- Home equity loans: Just like other loans, these give you an upfront lump sum of cash that you repay over a set term. Interest rates are typically fixed, which keeps monthly installments the same. This offers predictability, though it's best for those who know exactly how much they need to borrow.
- Home equity line of credit (HELOC): HELOCs are a form of revolving credit. Rather than receiving a lump sum, you gain access to a line of credit you can draw from and reborrow as you repay. HELOC rates are usually variable and come with a draw period, often 10 years, during which time you can borrow money you'll make interest-only payments on. When the draw period ends, you repay the remaining balance in installments. HELOCS offer flexibility, though payments fluctuate and may be harder to budget for.
Pros and Cons of a Second Mortgage
- Home equity loans and HELOCs allow you to access equity in your home, preventing you from having to turn to more costly forms of unsecured debt like credit cards.
- Lenders often cover some or all of the closing costs for second mortgages, which can save you thousands compared with refinancing.
- Taking out a second mortgage is often less difficult and time-consuming than doing a cash-out refinance, making it more useful if you need cash quickly.
- A second mortgage means another monthly debt payment on top of your first mortgage—which is a stretch for some budgets.
- Second mortgages use your home for collateral, so you could lose your home if you can't repay it. Due to these high stakes, you must be absolutely sure you can afford the payments.
- Because a second mortgage is separate from your first, you don't have the opportunity to change any of your original mortgage terms, such as nabbing a lower interest rate.
Should You Get a Second Mortgage or Refinance?
Whether you should refinance or take out a second mortgage depends on your situation and your goals. Here are two scenarios:
- You need money for a major expense. If your goal is to access funds to cover a large expense, you could opt for either a cash-out refinance or a second mortgage. If flexibility is a concern, such as a major home renovation that could have unpredictable costs, a second mortgage—especially a HELOC—could be a better fit than a cash-out mortgage.
- You want a better mortgage interest rate. If your goal is to reduce your mortgage payment, your best bet is to do a rate-and-term refinance. Perhaps market conditions have led to significantly lower interest rates, or your credit has improved significantly and you could qualify for a better rate now. Unlike a cash-out refinance or second mortgage, you don't get money to spend, but you get a new mortgage with more favorable terms.
Get Your Credit Ready
Whether you decide to refinance or take out a second mortgage, your credit will be carefully reviewed by lenders. Those with higher credit scores are more likely to be approved, and they often receive better terms.
Before you apply for a refinance or second mortgage, you can bolster your credit by lowering your current debt balances and continuing to pay every bill on time. To track your progress, use free credit monitoring from Experian, which alerts you to changes in your credit as they happen.