How to Choose Between a Refinance, a HELOC and a Second Mortgage

Alyssa Furtado
by Alyssa Furtado December 11, 2013 / No Comments

Flickr: dolmansaxlil

If you’re considering accessing the equity in your home, you have three methods to choose from: you can refinance your mortgage, obtain a home equity line of credit (HELOC) or take out a second mortgage. There are different qualifying criteria and reasons to choose each method, so the first question you should ask yourself is which option makes sense for you

The chart below shows the differences between your three options. Keep reading and we’ll also look at three case studies that show when each method is the right choice.

Refinance-Blog-Post

Ruby’s Refinance
Home Value: $350,000
Outstanding Mortgage: $225,000
Current Mortgage Term and Rate: 5-year variable at 5.00%
Years into Term: 3 years
Objective: Access equity for post-secondary school

Ruby wants to access some equity from her home, so she can pay for her child’s post-secondary education. She’s decided to refinance her mortgage, because she wants to access a lump sum of money and lock into a better mortgage rate than the one she currently has.

Through a refinance, Ruby can access up to 80% of the value of her home – less what she currently owes on her mortgage; this means Ruby can access $55,000 of equity:

Home Value x 80% – Outstanding Mortgage = Available Equity
$350,000 x 80% – $225,000 = $55,000

According to our mortgage refinance calculator, Ruby will have to pay a one-time prepayment penalty of $2,813 (three months’ interest) to break her current mortgage. However, doing so will give her access to the equity she needs for her child’s education, as well as a lower mortgage rate.

Even though she’s taking out equity and increasing her outstanding mortgage from $225,000 to $280,000 ($225,000 + $55,000), her new monthly mortgage payment is now much lower (from $1,745 down to $1,398) because of her new 5-year fixed rate of 3.29%, which will save her thousands of dollars over the remaining term.

It’s important to note that if the prepayment penalty was too large, Ruby could have considered blending and extending her mortgage instead.

Harry’s HELOC
Home Value: $400,000
Outstanding Mortgage: $300,000
Current Mortgage Term and Rate: 5-year fixed at 3.50%
Years into Term: 1 year
Objective: Access equity for a kitchen remodel

Last year, Harry bought his first home. Fortunately, he was able to make a large down payment, so he already has a good amount of equity in his home. Unfortunately, his kitchen is seriously outdated and needs a massive renovation.

With the renovation expected to last eight months, Harry has decided to get a home equity line of credit (HELOC) to finance his kitchen remodel, because it would give him the opportunity to access equity as he needs it.

Through a HELOC, Harry can access up to 80%* of the value of his home, – less what he currently owes on his mortgage; this means Harry can access $20,000 of equity:

Home Value x 80% – Outstanding Mortgage = Available Equity
$400,000 x 80% – $300,000 = $20,000

*It’s important to note that the HELOC amount can’t exceed 65% of the home’s value, but $20,000/$400,000 = 5%, which is much less than 65%.

Opening a HELOC is a good option for Harry, because the cost of refinancing would be very high. According to our mortgage refinance calculator, he would have to pay a $5,875 prepayment penalty to refinance.

A HELOC also gives Harry access to a revolving line of credit at a variable rate of Prime + 0.50**, so he can borrow money as he needs it throughout his kitchen renovation project.

Note that Harry will now have to make a monthly HELOC payment, in addition to his existing mortgage payment.

**Today’s best HELOC rate in Ontario.

Suzy’s Second Mortgage
Home Value: $325,000
Outstanding Mortgage: $260,000
Current Mortgage Term and Rate: 5-year fixed at 3.69%
Years into Term: 2 years
Consumer Debt: $25,000 total on 3 credit cards, all at 19.99%
Objective: Borrow money to consolidate consumer debt

Suzy wants to consolidate $25,000 of credit card debt she has accumulated over several years. A second mortgage is the right choice for Suzy, because of her bad credit – a problem she’s now facing, because of late and missed payments on this debt.

With a second mortgage, Suzy can access up to 90% of the value of her home – less what she currently owes on her mortgage; this means Suzy can access $32,500:

Home Value x 90% – Outstanding Mortgage = Second Mortgage
$325,000 x 90% – $260,000 =  $32,500

Of course, there are some other fees involved, including an appraisal fee, legal fees and second mortgage application fees. But if Suzy could access a second mortgage of $32,500 with an interest rate of only 10.00%, she could consolidate her debt at an interest rate that is much lower than what her current credit cards are charging her, and use the $7,500 difference ($32,500 – $25,000) to pay the fees.

With a second mortgage, Suzy will now have two monthly payments to make: her existing first mortgage payment and her new second mortgage payment.

These are just three examples of when a homeowner may want to access equity from their homes. Knowing which option is right for you could save you thousands in interest, fees and charges, so take your time to research each method and speak to a mortgage broker if you have any unanswered questions.