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If you have a home equity loan, you might consider refinancing it by taking out a new home equity loan, a new home equity line of credit (HELOC), or a new, larger first mortgage. The goal may be to get a lower interest rate, extend the term of your loan, or get more money. Whatever your motivations might be, this article will explain your various options, along with their pros and cons.
Key Takeaways
- You can refinance a home equity loan before its term ends, but you’ll want to check on whether you’ll owe a prepayment penalty.
- Refinancing can get you a lower interest rate, extend the term of your loan, or get you more money.
- You can refinance by taking out a new home equity loan, a HELOC, or a new first mortgage.
- Be prepared to provide all the necessary paperwork to be approved.
How to Qualify to Refinance Your Home Equity Loan
Just as when you applied for your original mortgage or current home equity loan, lenders will want to see proof that you’re not a lending risk. If you’ve lost your job or suffered some other financial reversal since then, you may have a more difficult time getting approved.
When you apply, the lender will typically want to see some financial information, including:
- Pay stubs or other evidence of your income
- A recent tax return or two
- Bank and investment statements
- Information on all of your current debts
You will also need to have a fresh home appraisal, no matter how recently you took out your current home equity loan. The lender will usually arrange for an appraiser of its choosing, but you will have to pay for it.
The lender will also check your credit score and possibly review your credit reports. To get a competitive interest rate, you’ll generally need a FICO score well over 600, or the equivalent Vantage score. (Some lenders set the minimum score at 620, others at 660 or even 680.) If your score is lower than that, you may still qualify for a loan, although with a higher interest rate and/or for a lesser amount.
Based on this information, the lender will perform several additional calculations:
- Debt-to-income (DTI) ratio: This is calculated in two ways—and some lenders may use both. Your front-end DTI looks at how much of your gross monthly income applies to mortgage payments. Your back-end DTI compares your gross monthly income to your total monthly debt obligations, which, in addition to mortgages, can include car loan payments, student loans, and other debts. As a very general rule, lenders want to see a front-end DTI no higher than 28% and a back-end one that’s under 43%.
- Combined loan-to-value (CLTV) ratio: The CLTV ratio compares the total outstanding balance of all loans on the property (including any first mortgage you might still be paying on, your home equity loan, etc.) to the current fair market value (FMV) of the property as determined by an appraiser. Most home equity lenders want to see a ratio of 85% or less. So if you currently owe the equivalent of 50% of your home’s value, you might be able to borrow as much as an additional 35%.
Warning
Some home equity loans impose prepayment penalties if you want to pay them off early. So it’s worth checking your loan agreement before you even explore refinancing.
Ways to Refinance Your Home Equity Loan
If you’re looking to refinance your home equity loan, there are several ways to go about it, depending on what your goals are.
Option 1: Refinance Into a New Home Equity Loan
This is the most straightforward technique. You simply apply for a new home equity loan that is at least large enough to pay off your existing loan. You might be able to get a lower interest rate and/or a shorter or longer loan term.
- Pros: Either a lower interest rate or a longer loan term will reduce your monthly payments. You might also be able to borrow more money and maintain roughly the same monthly payments that you have now.
- Cons: A longer loan term, if that’s what you choose, can mean paying more interest in total over the lifetime of the loan. Any home equity loan you take puts your property at risk if you can’t keep up with the payments, so you won’t want to take on more debt than you can reasonably manage.
Option 2: Refinance Into a Home Equity Line of Credit (HELOC)
Unlike a home equity loan, a home equity line of credit (HELOC) allows you to borrow money as needed, up to a defined credit limit, during your draw period, often five or 10 years. It is a revolving credit line that you can continuously tap into as long as you keep making your payments.
You could use a HELOC to pay off your home equity loan and keep your remaining credit line in reserve for other expenses in the future.
- Pros: While your HELOC is in its draw period, you may have the option to make interest-only payments. (When the draw period ends and the repayment period begins, you have to pay both interest and principal.) Paying the interest-only portion can reduce your monthly payments.
- Cons: The major downside of a HELOC vs. a home equity loan is that HELOCs typically have variable interest rates, which will change over time and could end up substantially higher. So you will lose the predictability you had with the loan you’re refinancing. If you go the interest-only route, you’ll face a sharp increase in your monthly payments once the repayment period kicks in.
Option 3: Refinance Into a New First Mortgage
With this option, you take out a new mortgage to pay off both your first mortgage and your home equity loan.
- Pros: By consolidating the two loans in this manner you’ll only have one bill to pay each month. In general, regular mortgages tend to have lower interest rates than home equity loans, so you could see some savings.
- Cons: Doing this will only make sense if you can get a significantly better rate on the two loans combined than you were paying on them separately. You are also likely to have to pay closing costs, which often run about 2% to 5% of the amount you borrow. Keep in mind that the lender secures a lien on your property until you pay off the mortgage.
Where to Refinance Your Home Equity Loan
You can obtain a new home equity loan at many financial institutions, including banks, credit unions, and online lenders. You should plan on applying with several different lenders so you can choose the one with the most attractive terms. A good place to start might be your current lender or another financial institution where you already do business.
Should I Do a Cash-Out Refinance to Pay off My Home Equity Loan?
A cash-out refinance is a type of mortgage where you borrow more than you need to pay off your first mortgage and use the remaining cash for whatever you want to. That could include paying off a home equity loan. Bear in mind that you’ll now owe more on your home, which is likely to mean higher monthly payments.
Is It Worth Paying the Closing Costs to Consolidate My First Mortgage and My Home Equity Loan?
That will depend on whether you’re able to get a significantly lower interest rate on the new loan, enough to more than make up for those closing costs. Rather than paying closing costs out-of-pocket, you might have the option of rolling them into your loan amount, but that means you’ll be paying interest on them month after month until your loan is finally paid off.
Should I Refinance My First Mortgage When I Refinance My Home Equity Loan?
Whether to refinance your first mortgage depends largely on whether you can get a lower interest rate or lower monthly payments by doing so. Another possible consideration is whether you want to switch from one type of mortgage to another, such as from an adjustable-rate mortgage (ARM) to a fixed-rate one.
What if I Don’t Qualify to Refinance My Home Equity Loan?
If you’re trying to refinance your home equity loan because the payments have become unaffordable and your credit score or other factors make you ineligible for a new one, you should contact your lender or loan servicer before the problem gets worse. The lender may agree to a loan modification to help you to stay in your home (and so it doesn’t have to take a big loss).
The Bottom Line
Refinancing a home equity loan isn’t all that different from taking out a first mortgage or other loan. You’ll need to provide enough information to convince lenders that you’re a good risk, and you’ll want to shop around because rates can vary from one lender to another. If your credit score is holding you back, you might want to wait a while before applying so you can try to improve it.
