Mortgage Refinancing and Home Equity Loans: The Benefits and Pitfalls

Refinancing an existing mortgage and taking a home equity loan have similarities but are two different financial events. Interest rates are low and many people are considering refinancing or obtaining a home equity line of credit. Equity in your home is required to qualify for either loan and unfortunately for many housing prices have dropped significantly.

Mortgage Refinancing

In mortgage refinancing a home owner is literally taking out a new mortgage and paying off the current mortgage. Here are several reasons why people refinance:

1. A better interest rate - overwhelmingly most mortgage refinancing is initiated to obtain a better interest rate and lower the cost of the loan.

2. Cash out some equity - the home owner may want to exchange some of the equity in the home for cash.

3. Change in the type of the loan - home owners with an Adjustable Rate Mortgage (ARM) may wish to move to a fixed rate mortgage.

4. Change in the term - home owners may wish to change the term of the mortgage. Extending the term would lower the monthly payment over a longer period; decreasing the term would increase the monthly payment but would pay the loan off sooner.

Things to Consider Before Refinancing

1. The refinancing process is the same as the mortgage process you went through when you first purchased your home. You will need equity in your home and your credit rating will be checked.

2. Expect the same types of closing costs that you incurred when purchasing your home; generally the closing costs on a refinance run 3-6% of the amount of the loan. Be prepared for application, loan origination, points, appraisal, inspection, attorney and title insurance fees.

3. Factor in the length of the current mortgage and when you plan on selling your home. If the remaining term on your mortgage is relatively short or you plan on selling your home in the next few years it may not be worth refinancing.

4. Be wary of "no cost refinancing", these lenders may incorporate closing expenses in the mortgage interest.

5. Contact your current mortgage lender and tell them you are considering refinancing; they may lower your interest rate.

6. Shop around before you refinance and understand the small print; some lenders may not allow pre paying the mortgage off.

7. Do your homework and use a mortgage refinancing calculator to determine your break even point. I have included a link to a mortgage refinancing calculator in my sources.

Home Equity Lines of Credit

A home equity line of credit is a form of revolving credit where the equity in your property is the collateral for the loan. Once a home equity loan is approved the lender issues checks to the borrower who can then write checks against the line of credit.

Things to Consider Before Obtaining a Home Equity Line of Credit

1. You must have equity in your property and the equity in your home is the collateral for the loan: if you can't make the payments your house is at risk.

2. Your lender will do a credit check.

3. Expect closing costs similar to those in the mortgage refinancing scenario.

4. As a general rule of thumb, lenders will established a credit line up to 75% of the equity you have in the property.

5. Understand the interest rates; they are usually variable and based on an index such as the interest rate on a Treasury bill plus a mark up.

6. Understand the repayment terms; some require interest only payments while others require interest and some principal.

7. Check to see if there are any ongoing fees, such as, an annual membership charge. Also check to see if the home equity loan has a term; some have limits, for example, 10 years.

8. Understand the conditions of the home equity loan; many lenders require a minimum amount of at least $100 when you write a check.

9. Shop around and compare home equity lines of credit from different lenders.

On both types of loans check the record of the various lenders you are considering with your regional Better Business Bureau (BBB).

Sources:

The Federal Reserve Board: "A Consumer's Guide to Mortgage Refinancings".

http://www.federalreserve.gov/pubs/refinancings/default.htm

The Federal Reserve Board: "What you should know about Home Equity Lines of Credit"

http://www.federalreserve.gov/pubs/equity/equity_english.htm

Refinancing Calculator

http://zwicke.nber.org/refinance/index.py

Better Business Bureau

www.bbb.org