Think About Why You Want to Refinance
There are a few scenarios in which refinancing a home equity loan makes sense. Your reason will help determine which refinancing option to pursue.
You want to reduce your interest rate or swap between a fixed- and adjustable-rate loan: Home equity loans, like mortgages, have interest rates based on market rates. If market rates have fallen, refinancing lets you replace your existing loan with a new one at a lower rate. You want to reduce your monthly payments: Securing a lower interest rate is one way to do this, but you can also extend the term of your loan. This will increase its overall cost but reduce the amount you pay each month. If you want to refinance for either of these reasons, you’re best off getting a new home equity loan. You want to get equity out of your home again: For instance, if you took out a home equity loan for $100,000 and have paid back $50,000, you can refinance with a new loan for $75,000, then access $25,000 in the equity.
Qualify for a Home Equity Loan Refinance
When you apply to refinance a home equity loan, you’ll need to qualify. This involves proving that you can repay the loan and showing the lender how much equity you have. Here’s what the lender will base their decision on:
Income and Expenses
You’ll be required to give proof of your income and expenses by providing income tax returns, pay stubs, W-2 forms. and bank statements.
Home Equity
Because the loan is secured by your home, the lender will want to know how much the portion of your home that you own (your equity) is worth. For that, you’ll need to pay to get your home appraised. You can do this by paying for a full appraisal, though some lenders may allow you to get a drive-by (exterior only) appraisal, a desktop appraisal (based on publicly-available records), or an automated valuation model (AVM) appraisal, which is generated by an algorithm.
Credit Score
Lenders will also pull your credit report and look at your credit score. You’ll be eligible for the best rates if your credit score is in what’s considered the “very good” or “exceptional” range (740-850 for FICO scores). You may still qualify for a refinance with a lower score, but you may have a harder time finding a lender and will likely pay a higher interest rate.
Debt-to-Income Ratio
Lenders will also look at your debt-to-income ratio (DTI) to make that you won’t be so stretched by the new loan that you can’t pay it back. Your DTI compares your total monthly debt payments plus the payments on the loan you’re applying for to your monthly gross income.
Combined Loan-to-Value Ratio
One other important piece of information lenders consider is your combined loan-to-value (CLTV) ratio. That’s the total value of all the secured loans on your home (including the one you’re applying for) divided by the home’s current appraised value.
Options for Refinancing a Home Equity Loan
There are three primary ways to refinance your home equity loan: get a new home equity loan or a new home equity line of credit (HELOC), or do a cash-out refinance of your primary mortgage.
1. Refinance Into a New Home Equity Loan
You can apply for a new home equity loan to replace your existing loan if you have enough equity. Simply use the proceeds of the new loan to pay off the existing one. You’d do this if the new loan can give you a better interest rate or a longer loan term (or both). Pros: With a lower rate or longer term, you should be able to shrink your monthly payments (or borrow more money without increasing your payments). And there don’t have to be extra refinancing costs involved. Many banks will pay your closing costs on the new loan as long as you don’t pay off the loan early. If you do, you may have to pay back some of the closing costs. Cons: The new loan could cost you more in interest in the long run if you get a longer term—even if you get a lower rate. Also, if you borrow more than you had before, you increase your risk of overextending yourself and possibly losing your home if you’re unable to keep up with payments.
2. Refinance Into a Home Equity Line of Credit (HELOC)
A home equity line of credit is also secured by your home, but works more like a credit card. Rather than getting a lump sum loan with a fixed repayment schedule, you get a line of credit that you can borrow against as you need within a set time period. Pros: You could be able to significantly lower your monthly payments for a while because during the HELOC draw period (typically the first 10 years), you usually only have to make interest payments. Cons: HELOCs usually have variable interest rates, while home equity loans have fixed rates. Depending on the rate of your original loan, you could end up paying more in interest if rates go up when you have the HELOC.
3. Get a Cash-Out Refinance of Your First Mortgage
A cash-out refinance of your primary mortgage enables you to use the cash you take out to pay off your home equity loan. With a cash-out refinancing, you refinance your existing mortgage to a higher balance. For example, if you owe $200,000 on your mortgage, you can refinance to a $250,000 loan to access $50,000 you can use for other purposes, such as paying off your home equity loan. Pros Refinancing a home equity loan this way simplifies payments. Where you previously had to pay both your mortgage and home equity loan bills, now you only have one to pay. Another perk is that cash-out refinance rates are often lower than home equity loan rates (though not as low as rate-and-term refinance rates), making this one way to reduce the interest that accrues on your remaining home equity loan balance. Cons You may have significant closing costs with a cash-out refinance. In addition, you’ll need to make sure you’re not in danger of getting hit with prepayment penalties for either loan.
Consider the Risks Before You Refinance
Refinancing does involve some risks you need to consider. One is that refinancing isn’t free. Many lenders charge origination, closing, or other fees, so refinancing means paying those costs. If your goal is to save money by refinancing, you need to account for those charges when deciding whether this is the best option for you. You also have to think about the value of your home. If your home’s value has dropped, refinancing might be difficult or cause your equity to decrease to the point that you’ll have to pay for mortgage insurance. Also, consider that your home serves as collateral for home equity loans. If you fail to make payments because you’ve taken on too much debt, the lender could foreclose and you might lose your home.
The Bottom Line
Refinancing a home equity loan is possible and can help you adjust the terms of your loan or lower your monthly payment. However, it’s important to keep the risks in mind and make sure that refinancing will help you reach your long-term goals.
