Refinancing a home equity loan
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You’ve probably read and heard plenty about refinancing your mortgage for better terms. Since a home equity loan is essentially a second mortgage, can you refinance it too? The short answer: Yes. You might be able to refinance a home equity loan as you would a first mortgage. Here’s how it works and what to know.
Can you refinance a home equity loan?
To refinance a home equity loan , you’ll need to have enough equity (an outright ownership stake) in your home, taking into account all of the loans and mortgages tied to the property. Most lenders require you to have a combined loan-to-value (CLTV) ratio of no more than 85 percent, meaning the sum of your mortgage balances makes up no more than 85 percent of your home’s total value. While you’ll have already met this benchmark when you first got your home equity loan, you’ll have to revisit it if you want to refinance — it’s possible your home’s value dropped since you first took out the loan.
Common reasons for refinancing a home equity loan
There are several good motives for refinancing your existing home equity loan. They include:
- Reduce your monthly payment. Often, refinancing your home equity loan will result in having to pay less each month. This happens in one of two ways: You score a better (i.e., lower) interest rate on the new loan, or the new loan has a longer term.
- Lock in a lower interest rate. Many people refinance their home equity loans because interest rates have significantly dropped. Locking in a more favorable interest rate can make a significant difference in monthly payments.
- Switch from an adjustable rate to a fixed rate. If your home equity loan currently carries a variable rate, switching to a fixed-rate loan offers more stability. You will have a predictable payment each month instead of one that fluctuates with interest rate trends. (Conversely, you may want to ditch a loan with a high fixed rate in favor of the variable rate variety, if interest rates seem to be on a long-term downward course.)
- Borrow additional funds for projects. Homeowners taking on a major repair (damaged roof, non-functioning furnace) or remodel (renovate the kitchen, add a bathroom) often find home equity loans the most affordable way to fund these five-figure projects. Not only do these loans often have lower rates than personal loans or credit cards, the interest can be tax-deductible when used for home improvement.
- Customize repayment terms. If you have a 15-year repayment term on your home equity loan with 10 years left, refinancing gives you the opportunity to change those terms. You can either shorten the terms to pay it off more aggressively or lengthen it to allow yourself more time to complete the loan.
Can you refinance an existing mortgage with a home equity loan?
No. Your home equity loan is a second mortgage that allows you to borrow against your home’s equity. It can’t replace your first mortgage. If you want to refinance your home’s existing mortgage while tapping into its equity, a cash-out refinance is something to explore.
Pros and cons of refinancing a home equity loan
The benefits to refinancing a home equity loan include:
- Lower your monthly payments: All else being equal, if you can get a lower interest rate, you’ll save on your monthly payments and interest overall.
- Shorten or stretch your repayment term: Transitioning to a longer term, such as 10 years instead of five, will decrease your monthly payment but also add to your interest charges. Alternatively, you might opt for a shorter loan term, which raises your monthly payments but allows you to pay off the debt faster, saving you on interest and freeing up room in your monthly budget sooner.
The drawbacks to refinancing a home equity loan include:
- Prepayment penalty: Depending on the type of home equity loan and your lender’s policy, you might be subject to a fee if you pay it off early (which is essentially what refinancing does) or before a certain time frame.
- Repayment risks: If you can’t keep up with the payments on the new loan (say you converted to a shorter-term loan with a higher monthly payment), you open yourself up to the possibility of foreclosure. Likewise, if your home declines in value, you might not be able to refinance at all.
Bottom line on home equity loan refinances
As with a regular mortgage refinance, you have to apply for a refinance of your home equity loan, either with the current lender or another one. Be prepared to provide credit and financial information to the lender, along with a list of assets and liabilities.
In general, the best reason to refinance a home equity loan is if rates have dropped since you took it out. Just be sure to consider your timeline for staying in the home, be aware of any change in your home value, and take into account any fees you might incur (yes, refinances incur closing costs, just like the original loan did).
Additional reporting by Lara Vukelich