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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. You’ll need to have enough equity (an outright ownership stake) in your home, taking into account all of the liens on the property. You’ll also have to meet some other qualifications.
How to refinance a home equity loan
Refinancing a home equity loan, involves replacing your existing loan with a new one, potentially to secure a lower interest rate, adjust the repayment term, or tap additional equity from your home’s increased value.
Let’s say you have an HE loan that you took out a few years ago at 8 percent, the then-prevailing interest rate. Since then, general interest rates have dropped, and now loans are available at 6.5 percent. Additionally, your home’s value has increased, and you’ve built up more equity. By refinancing, you could lower your monthly payments. You could also restart the clock on your repayment schedule (for a longer or shorter term), or even borrow more cash.
Steps to refinancing your home equity loan
- Assess your position: It starts with determining whether refinancing is beneficial for you. Look at the current interest rates compared to what you have, calculate potential savings over time, and consider how long you plan to stay in the home (you want it to be long enough to “break even” – that is, have the savings outweigh the costs you’ll pay upfront to refinance).
- Equity check: Calculate your current equity stake. If your home’s value has increased, for instance, from $250,000 to $300,000, and you have paid down your mortgage and previous home equity loan to a total outstanding amount of $200,000, you have $100,000 or a 33 percent equity stake — enough to consider refinancing.
- Credit score review: Check your credit score because a good score can lead to better interest rate offers. For example, raising your credit score from 670 to 740 might drop your rate by a whole percentage point.
- Shop for lenders: Reach out to several lenders to find the most favorable rates and terms. For example, one lender might offer a 4.5 percent interest rate with no closing costs, while another could offer 4.25 percent with closing costs. You’d want to choose the latter.
- Document preparation: Gather important documents such as recent pay stubs, tax returns, and bank statements which prove your income and financial stability.
- Understand the costs: Know the associated expenses of refinancing. These might include application fees or an early payoff penalty on your existing loan. For example, if your lender charges a 2 percent prepayment penalty on your $20,000 home equity loan, you’ll owe $400.
- Decide on the loan type: Based on your goals, decide if another fixed-rate home equity loan, a variable home equity line of credit (HELOC), or a cash-out refinance works best for you. A HELOC might offer a good option if you prefer to access your equity on a rolling basis, rather than a lump sum. A cash-out refi would probably offer a lower interest rate, but it does involve replacing your current mortgage.
- Loan application: Apply for the new loan. Depending on the lender’s requirements, a new property appraisal might be needed to assess your home’s current value.
- Review offers: When you get offers, compare the details, being sure to look at the annual percentage rates — the APRs give a truer sense of the total cost of the loan, since they include fees. If you’re going for a variable-rate HELOC, be sure you understand how often rates will fluctuate and by how much per year.
- Close the loan: At closing, settle any upfront costs. Apply the new loan to pay off your existing home equity loan. Then, your new payment plan begins according to the fresh terms.
How to qualify to refinance a home equity loan
Having the old loan doesn’t automatically make you eligible for the refinance. Just like the first time around, you need to be able to qualify
For a home equity loan, the first requirement is that your home serves as adequate collateral to secure the loan. Most lenders require you to have a combined loan-to-value (CLTV) ratio of no more than 85 percent, meaning the sum of all your outstanding home-backed debts (primary mortgage, home equity loan) makes up no more than 85 percent of your home’s total value. In other words, you own at least 15 percent of your home free and clear.
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.
This isn’t a common situation to face, but it can happen if the residential real estate market has softened significantly. It may also happen if you’ve done a cash-out refinance of your mortgage, and took a good chunk of equity out of the home.
You also need to meet personal financial and credit requirements. That means having at the very least a fair credit score — starting at 580 —though many lenders require a 620 minimum for refinances in general. Standards for home equity loans tend to be tougher, though, because these second mortgages fall behind primary mortgages in the pecking order of creditor repayment should you default. According to Experian, you’ll usually need a credit score of at least 680 to qualify for a home equity loan, and many lenders prefer a credit score in the 700s. Even among lenders who work with “bad credit” candidates, the average minimum is around 630.
Keep in mind: Basic loan approval aside, the higher your credit score, the lower the interest rate you'll be offered on the loan.
You also have to have sufficient income to make payments on the loan and a low debt-to-income ratio (DTI) — that is, the monthly bills you pay should generally comprise no more than 43 percent of your monthly gross income.
Finally, you should have a good repayment record with the current home equity loan — especially if you want to refinance with the same lender. They may be hesitant if you’ve missed payments, been late or fallen short. Conversely, if your financials are a little weak but your record is solid, they may cut you some slack, given you’ve been a reliable borrower as far as their loan is concerned.
Common reasons for refinancing a home equity loan
There are several good reasons to refinance 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 home renovation funds. Homeowners taking on a major repair (damaged roof, non-functioning furnace) or remodel often find home equity loans the most affordable way to fund these five-figure projects. If you’ve got a job that’s running above budget, or you’ve augmented it in some way, a refinance could get you help, with the same potential tax benefits and lower costs.
- 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 term 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.
- At the mercy of the market: If your home declines in value, you could wind up being underwater — that is, owing more between your mortgage and home equity loan than the home is worth. If the real estate market has already softened, you might not be able to refinance at all.
- Increase the interest: Refinancing your home equity loan will reset the repayment term; unless you specifically chose a shorter loan, this means it will extend the debt. That can lower your monthly payment but means you’ll pay more money in interest, for longer. If you go to sell the home, that could mean a bigger bite into your proceeds, as you’ll have to pay off the home equity loan immediately.
Can you refinance a home equity loan into a HELOC?
Yes, you can definitely refinance a home equity loan into a home equity line of credit (HELOC), but it’s vital to weigh the potential benefits against the drawbacks.
Benefits of refinancing into a HELOC
- Potential for lower interest rates: If market interest rates have fallen since taking out your original loan, switching to a HELOC could help you secure a lower rate, reducing overall interest costs. And you’d benefit from additional declines throughout the HELOC’s term, as your rate would adjust with the market.
- Flexibility: Unlike the lump-sum payout of a home equity loan, a HELOC provides you with a revolving line of credit. This allows you to tap into funds as and when you need them, offering enhanced financial flexibility.
Downsides to refinancing into a HELOC
- Variable interest rates: The variable-rate nature of a HELOC means your rate fluctuates over time. While this could lead to lower payments if rates drop, it could also result in higher payments if rates increase.
- Extra costs: Some HELOCs charge a transaction fee each time you withdraw, and others charge inactivity fees. Many also come with annual maintenance fees. While small, these could eat into your savings from lower rates.
- Harder to qualify: Lenders want to be sure you can handle fluctuating payments, so their HELOCs may have more stringent requirements. For example, online lender Spring EQ sets a minimum credit score of 680 for is HELOC, but only 620 for a home equity loan.
Can you refinance a home equity loan and your mortgage at the same time?
Yes, it is possible to refinance both a home equity loan and your primary mortgage simultaneously. This is typically achieved through a cash-out refinance, which entails taking out a larger mortgage than your current one, getting the difference in ready money. In this case, you can use the surplus funds to pay off your home equity loan
Advantages of refinancing both loans simultaneously
- Debt consolidation: This option allows you to combine your primary mortgage and home equity loan into a single payment, simplifying your financial management and potentially offering a lower overall interest rate than standard home equity loan (refis tend to run a percentage point or two cheaper).
- Access to cash: The “cash-out” part of a cash-out refinance means you end up with additional funds. If there’s anything left after paying off the home equity loan, you could use the cash for various expenses like home improvements, credit card bills or tuition.
Drawbacks to refinancing both loans simultaneously
- Potential for higher interest rate: Cash-out refinances often attract higher interest rates than standard rate-and-term refinances, which could lead to increased costs over the life of the loan. Also, the prevailing interest rate may be higher than that on your current mortgage.
- Increased loan amount and duration: You’ll essentially be taking out a larger loan, and extending your repayment period. This might lead to higher total interest payments, especially if you don’t plan on accelerating your payments to compensate for the reset amortization schedule.
A mortgage refinance is essentially getting a new mortgage — with all the costs and time-consuming procedures that implies. You might not want to let yourself in for the extra complications, if all you really need is to update your HELoan. It’s also not advisable if it means giving up a low interest rate on your present mortgage.
What to do if you are unable to qualify for a home equity loan refinance
If you find yourself in a situation where you are unable to refinance home equity loan due to qualification challenges, consider exploring these alternative paths to paying it off. Basically, these options involve exchanging one obligation for another.
1. Home equity sharing agreements: These agreements, which give you a lump sum, often have more lenient criteria, potentially suitable for those with lower credit scores or other weak financials. Technically, the money you receive is an investment in your home, not a loan: Instead of receiving regular monthly payments, the investing company takes a share of your home’s future value when you sell it or at the end of a specified period. However, if your home appreciates significantly, this could end up being more costly than traditional loan interest payments.
2. Reverse mortgages: Seniors (those aged 62 and up) can tap into their home equity by taking out these mortgages without monthly payments; instead, the loan is repaid when the home is sold or the borrower permanently vacates it. However, note that interest accrues on the loan balance over time, which can substantially increase the amount owed in the long run.
3. Personal loans: Unsecured personal loans can provide fast cash for emergencies or other needs. These loans generally carry higher interest rates than those secured by your home and shorter terms; they may have additional fees, as well.
If you’re looking to refinance your home equity loan because you’re struggling to afford the monthly payment, you can also reach out to your lender as soon as you’re able and ask them for options.
For example, your lender may be willing to put your payments in forbearance for a short period. This means you won’t have to make payments for a few months. That can be a big help if you’re only facing short-term financial issues.
You can also request a loan modification. Like refinancing, this can adjust the details of your loan, such as its interest rate, term, or monthly payment, making it more affordable. However, it does not require applying for a new loan.
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 many ways, it’s similar to the first time ‘round — though often, refinancing is easier, given that you’ll be applying for a smaller sum and likely have a good track record repaying the first debt. Still, you’ll want your financial profile to look as strong as it can.
In general, the best reason to refinance a home equity loan is if interest 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, a refinance incurs closing costs, just like the original loan did).
Additional reporting by Agnes Gaddis