An equity refinance is a method of restructuring a mortgage, essentially paying off an existing mortgage on a property with another. Effected by utilizing the existing equity in the property as the down payment, an equity refinance is done either to lower the periodic payments on the mortgage or to liquidate some of the borrower's equity in the property, or sometimes both. There are advantages and drawbacks associated with an equity refinance.
When a property is purchased, the purchase price generally is subsidized by a loan called a mortgage. Mortgage lenders generally require that purchasers put up a portion of the purchase price from their own funds as a down payment, after which the mortgage lender will pay the balance. The borrower is then obligated to make periodic payments, usually monthly, to the lender. Much of the payment pays the accumulated interest due, but some of each payment pays down the balance due on the loan. The equity in a property is the difference between its value and the total amount due on all mortgages. Thus, if the market value remains static, the equity increases gradually every month because of the periodic payments to the balance due.
In reality, though, the value of a property fluctuates with the market. Historically, this has meant that property values gradually increase. This accelerates the speed at which equity builds up in a property. However, even though the trend has always been for property values to increase, they don't do so all the time. Property values sometimes decline, as was experienced in the early years of the 21st century in the United States, after they had increased steadily, and sometimes rapidly, during the last two decades of the 20th century. When property values decline, equity vanishes.
In the refinancing process, the homeowner essentially sells the property to himself or herself. A new mortgage is applied for, generally at a better interest rate than the original mortgage, and the equity in the property represents the down payment. The new mortgage can be in an amount just sufficient to retire the old mortgage and pay the closing costs of the transaction; such refinances leave the equity intact and are made primarily to take advantage of better interest rates, reducing the periodic payments. Alternately, the new mortgage will be for an amount larger than the balance due on the old mortgage, with the excess usually disbursed to the borrower. These are known as “cash-out” refinances.
The advantage of a cash-out equity refinance is that it delivers cash to the borrower at the preferred interest rates usually associated with mortgages, rather than the higher rates charged for vehicle, business, and personal loans. A straight equity refinance without any cash out benefits the borrower by charging a rate of interest lower than the original loan, resulting in lower periodic mortgage payments and immediate savings. In many cases, it's also easier to qualify for an equity refinance because the loan is secured by the value of the property.
There are disadvantages to equity refinances, however, when large amounts of cash are taken from the property's equity. If the market experiences a downturn, for example, and the value of the property declines below the amount due on the mortgage, the borrower is considered “upside-down” and will have a very hard time selling the house because a sale at full market value won't pay off the balance due on the mortgage loan. An equity refinance that doesn't involve any cashing out of equity value, however, is usually considered a safe strategy for saving money.
