Home equity or mortgage refinance: Which should you choose?

Looking to refinance your first mortgage and take cash out at closing? Consider another option.

When the prime rate is below the average rate charged on 30-year fixed mortgages, consumers looking to tap their home equity may find it cheaper for them to get equity loans or lines of credit. Besides costing thousands of dollars less in closing costs, the rates on these loans may be lower than first mortgages. Although home equity loans and lines of credit are currently attractive, they aren't always the best option.

It can be beneficial to someone who knows they'll pay it off in a few years or who'll want to move out in a couple of years. But, if you need a longer time to pay off in order to keep payments reasonable, and can't afford a five-year or 10-year repayment schedule, a mortgage may be best.

First mortgage rates traditionally are the lowest rates around. Banks and loan investors feel the most secure with these loans because they have first lien position, meaning they'll get first rights to any money generated if foreclosed.

When first mortgage rates are lower than equity loan rates, it usually makes sense for a borrower to tap equity by going through a so-called cash-out refinance. In that process, the customer refinances the first mortgage, increases the balance and receives the difference between the old and new balances in cash at closing.

But rates don't always behave normally. Equity loans can actually end up being cheaper than first mortgages, even though most equity loans are riskier because they're usually in the second-lien position. The reason lies in the way banks set rates on various home loan products. Most first mortgages are bundled into mortgage-backed securities, or MBS, and sold into the secondary market via Fannie Mae and Freddie Mac.

When the Fed cuts rates, it usually helps the economy recover. So bond traders start to drive mortgage rates higher in anticipation of an eventual recovery, even though the Fed may still be cutting the rates it controls directly and the economy hasn't improved yet.

Home equity loans work differently, though. For one thing, banks have more say over the rates charged on those because they typically keep the loans on their books, rather than sell them off to third-party investors. Additionally, banks use yields on shorter-term bonds, such as two-year or five-year Treasuries as a guideline for their equity loan rates rather than yields on long-term MBS. Those shorter-term yields are much more sensitive to the level of the Fed-controlled fed funds rate than they are to the long-term economic outlook.

As for home equity lines of credit, most banks set their rates based on the shortest-term market rate of all, which is the Wall Street Journal prime rate. It moves in lock step with the fed funds rate.But equity loans and lines of credit usually come without closing costs, so they can be $2,000 or $3,000 cheaper than first mortgages.

So who should go for an equity loan or line of credit rather than a cash-out refinance mortgage? Consumers who plan to pay off their loans in a reasonable amount of time or who don't need to borrow much money may find an equity loan or line of credit the better than a cash-out refinance mortgage.

Regardless of bad credit or no credit, give our home equity loan lenders a chance to serve you and offer free refinancing interest rate quotes. A home equity loan is a great way to get a low interest, long term loan to pay off bills. But if you're a non-homeowner, consider credit counseling.

Ideas for using a home equity loan:

Refinance your home as a way to obtain other property, and use the equity as a construction loan to develop new real estate for a vacation home. If; for example, you want to purchase real estate as a second home or vacation site, you could use the equity in your home to purchase property. If there's enough equity, you could buy land plus a manufactured home, instead of obtaining a separate real estate and mobile home loan. Or, you could use the equity as a RV loan, a boat loan, or for other recreational purchases.
Having legal problems and need a large cash loan? Use your home's equity to fund your lawsuit loan.

Have children? Use your home's equity for a college loan. You may be able to get lower interest rates, better repayment terms, and a better tax deduction than by extending a long term student loan.

Using home equity often offers the lowest interest rate, versus that charged by an unsecured loan, and refinancing approval is much easier than an unsecured loan, even for bad credit people.