Refinancing Your Home or A home equity loan can help you pay for repairs and improvements and cover other expenses that result from owning a house. With this in mind, there may come a time when you want to refinance your home equity loan. This could be for several reasons, like lowering your monthly payment or taking advantage of lower interest rates.
Not everyone should refinance their home equity loan, however. It depends on your financial goals and current circumstances. If you’re unsure whether refinancing is right for you, this guide will help clarify things by walking through the process step by step and discussing the pros and cons.
What’s a Home Equity Loan?
A home equity loan is a kind of second mortgage. It allows you to borrow against the equity in your house — the difference between the amount you still owe on it and the value of your property — and receive a lump-sum payment in return.
You pay off the loan in monthly instalments (in addition to your present mortgage) over an extended period, usually anywhere from five to 30 years. However, if you can’t return the equity on your property, the lender may foreclose on it.
Although most people use home equity loans for renovations or household repairs, that’s not all they’re suitable for. Homeowners can also use them to pay off debt with higher interest rates, cover medical bills, and even finance their children’s education.
Can I Refinance My Home Equity Loan?
You can refinance a home equity loan similarly to a regular mortgage. Some reasons you might want to do this are the following:
- Lower Your Interest Rate: If current interest rates are lower than what you’re paying on your home equity loan, refinancing to get a lower rate could save you money. The amount of savings depends on how much lower the new rate is.
- Reduce Your Monthly Payment: Refinancing can also reduce your monthly payment, which can help you free up cash for other financial goals or to weather a financial emergency. The easiest way to reduce your payment is to refinance into a longer-term loan or a loan with a lower interest rate.
- Change Your Repayment Terms: You could extend your repayment term to reduce monthly payments but accrue more interest in the long run. If you want to save on interest costs, consider refinancing into a shorter-term loan.
- Tap Into Additional Equity: You might be able to use your home equity to cover other costs if you refinance.
- Switch From an Adjustable Rate to a Fixed Rate Mortgage: If you have an adjustable-rate loan (also known as a variable rate), you might want to refinance into a fixed-rate loan. With a fixed-rate loan, your interest rate will never fluctuate, making it easier for you to budget and plan financially.
Home Equity Loan vs. Cash-out Refinance
A cash-out refinance is when you get a new loan to replace your current mortgage. The new loan is for more than what you owe on your existing mortgage, and the difference is in cash. This lump sum of cash can be used for other expenses, but unlike with a home equity loan, there won’t be a second monthly payment.
You might refinance your home for cash if interest rates drop below your current loan’s rate or you just don’t want a second monthly payment. A home equity loan may be better if you want to keep the same terms on your first mortgage untouched.
If you have enough equity in your home, you may be able to do a cash-out refinance. This would enable you to use the money from the refinance loan to pay off your existing home equity loan. Lenders usually approve loans up to 80% of a borrower’s home equity for cash-out refinancing.
Pros and Cons of Refinancing a Home Equity Loan
Refinancing your home equity loan is a brilliant idea for some, but it isn’t right for everyone. Before you go through with it, think about the advantages and drawbacks.
Pros of Refinancing a Home Equity Loan
- You could lower your interest rate or monthly payment: If you refinance, you could end up with a lower rate, a smaller monthly payment, or both. Your savings depends on current interest rates and the loan term you choose.
- You might be able to pay off your loan sooner: If you reduce your loan term, refinancing may assist you in paying off your debt sooner.
- You may be able to tap into additional home equity: Refinancing can allow you to use more of your equity in your home and receive a larger lump-sum payment if you’ve improved your position.
Cons of Refinancing a Home Equity Loan
- It comes with closing costs: Home equity loans and cash-out refinancing generally come with closing costs of 2% to 6%. It might not be the best move if you’re not financially ready for this.
- It puts your home at additional risk: Home equity loans are secured by your home, which means that if you can’t make the payments, the lender could foreclose your house. If you have both a home equity loan and a mortgage, you’re more likely to face foreclosure if you lose your job or run into financial trouble.
- You won’t always get a lower rate: Your new interest rate will be determined by your credit and current interest rate climate. If you have a poorer credit score now than when you took out the loan, refinancing might result in a higher interest rate than you currently have.
Read More: How To Maximize Your Home Equity? Best Ways To Tap Into Your Home Equity.
How To Qualify To Refinance Your Home Equity Loan
Refinancing a home equity loan works similarly to refinancing the first mortgage. Lenders will evaluate your income, expenses, debt, and house value to determine if you qualify. To demonstrate that you can repay the loan you’re applying for, you’ll have to submit documents such as pay stubs, W-2 forms, bank account statements, and income tax returns (or temporarily give lenders safe access to your online accounts).
You will have to cover the entire appraised value of your home and additional appraisal types such as drive-by or automated valuation model (AVM) appraisals. Your lender uses this information about your home’s equity to help determine the interest rate. The lowest possible interest rate available to those with a FICO score rating in the “very good” or “exceptional” range is 740 – 850.
With a lower credit score of 620, you may still qualify to refinance your home equity loan at a cheaper rate. However, you will likely get a higher interest rate and might borrow less than if you had a better score. The pool of potential lenders might also be somewhat limited.
Lenders will take your current monthly debt obligations and add the monthly payment on the loan you’re applying for. If that number is over 50% of your gross income, it may be challenging to qualify for the loan. This calculation is called a debt-to-income (DTI) ratio. Some lenders have a lower maximum DTI limit, such as 43%.
Finally, you’ll need to have enough home equity after taking out the new loan to meet the lender’s guidelines for the combined loan-to-value (CLTV) ratio. This percentage is determined by dividing the total amount you’ve borrowed against your home by the property’s fair market value. Some lenders will allow homeowners with top-notch credit to borrow up to 100% of the value of their homes. However, it’s more likely that you’ll only be able to borrow 85% to 90%.
Example of a Home Equity Loan Refinance
Assume that your house is worth $250,000. You have an outstanding first mortgage of $165,000 and a home equity loan balance of $25,000. Your debt totals $190,000 and is borrowed against your home. Divide $190,000 by $250,000 to get your CLTV ratio. The result is 76%, which indicates that your home equity is 24%. The lower the amount of equity you borrow against, the cheaper your interest rate will be. Some lenders demand a CLTV no greater than 60% or 70% to obtain the lowest interest rate.
Option 1: Refinance Into a New Home Equity Loan
How It Works
You may switch to a new mortgage with the same amount of money — or more if you have enough equity. You’ll receive a new interest rate and loan term.
You may be able to decrease your monthly payment or borrow more without significantly increasing it if you get a lower interest rate and/or longer loan term. Unless you pay off the mortgage before the first 36 months, most lenders will cover most or all of your closing costs on a home equity loan. In that case, you’ll have to reimburse the lender for a proportionate share of the closing expenses it paid on your behalf.
Even if you obtain a lower interest rate, extending your loan term may result in more significant long-term interest costs. If your financial situation deteriorates, you risk losing your house if you take out a larger loan.
Option 2: Refinance Into a Home Equity Line of Credit (HELOC)
How It Works
A home equity line of credit (HELOC) might be a suitable option to pay off a home equity loan.
You can usually make interest-only payments during the HELOC draw period, which typically lasts ten years. Refinancing your home equity loan with a HELOC may result in significantly lower monthly payments.
If you take out a home equity loan, you usually have to pay a fixed interest rate. However, if you get a HELOC, the interest rate is variable. So, with a home equity loan, you’ll have a predictable monthly payment, but with HELOC, it could be higher or lower each month. In the long run, it probably will cost more because rates tend to go up over time.
Option 3: Refinance Into a New First Mortgage
How It Works
You can get a new interest rate and loan term by refinancing your home equity loan and first mortgage into one single loan. This effectively consolidates your loans with a rate-and-term refinance without increasing the amount you borrowed in the first place.
Rates on first mortgages are sometimes lower than home equity loan rates, allowing you to save money. You’ll have a consistent monthly payment and predictable borrowing costs if you refinance into a fixed-rate mortgage.
If your previous first mortgage is at a rate lower than what lenders are currently offering, it would not be profitable. Even if you can obtain a lower interest rate by refinancing, first mortgages may include significant closing expenses that can total 2% to 5% of the loan amount. In contrast, many lenders will reimburse your closing costs on a HELOC or home equity loan.
Read More: Is Now a Good Time to Refinance Your Mortgage?
Should You Do a Cash-out Refinance To Pay off Your Home Equity Loan?
A cash-out refinance is a strategic way to get out of an equity loan early if you also want to refinance your first mortgage and borrow more money. Cash-out refinancings generally have higher interest rates than home equity loans, although not as high as rate-and-term refinances. Your creditworthiness will determine the rate.
Homeowners should always be weary of owing more to their homes than they can afford to pay back. Payments become unmanageable when employment is lost or cut, preventing you from making the necessary monthly payments. If you fall too far behind, your home could go into foreclosure.
Is It Worth Paying the Closing Costs To Consolidate Your First Mortgage and Home Equity Loan?
You’ll need to figure out your breakeven period and see how many months you’ll have to repay the new loan before you break even after paying closing costs. The shorter the breakeven period, the better. If you finance your closing costs, it will alleviate some of the pain in the short run. However, by spreading closing costs over the years, you will pay interest on them for years to come.
Paying higher interest rates is another way to avoid paying closing costs. However, this isn’t the ideal method if you’re trying to get a lower rate by refinancing.
Should You Refinance Your First Mortgage When You Refinance Your Home Equity Loan?
Are you in a position to pay the extra money for closing costs if refinancing your first mortgage? If not, what factors prevent you from doing so, and how will that impact your financial situation? What questions do you have about refinancing your first mortgage?
- Do you have an adjustable-rate mortgage (ARM) that you wish to replace with a fixed-rate loan because interest rates are rising?
- Is your loan interest rate higher than current market rates?
- A conventional loan may be cheaper if you have an FHA loan and your credit has improved. This is because your home equity may have increased.
What if You Don’t Qualify To Refinance Your Home Equity Loan?
Contact your loan advisor as soon as possible if you can’t refinance your home equity loan and the payments have gotten too expensive. If you’ve had a financial problem, your service provider may be willing to modify your loan terms to make the payments more affordable.
The Bottom Line
You could lower monthly payments by refinancing your home equity loan into another home equity loan, HELOC, or first mortgage. To ensure you’re getting the best deal, apply for multiple loans with different lenders and compare their offers. Your credit score won’t be affected as long as you shop around within a 45-day window and submit all applications on the same day.
You’ll be able to obtain a lengthy loan quote for each application. Determine which offer provides you with the most excellent mix of short-term affordability and long-term financial stability. If refinancing isn’t an option, contact your home equity loan advisor about a loan modification.
Do you have any questions about refinancing your home equity loan? Leave a comment below or contact us for a free consultation.