You may be considering refinancing your home equity loan for a variety of reasons. You may choose to reduce your monthly payments by obtaining a lower interest rate or extending the term of your loan, or you may wish to borrow against a larger portion of your home’s equity for a substantial purchase or renovation. Regardless of your motivation, here are your alternatives along with the benefits and downsides of each.
Table of Contents
How to Qualify for a Home Equity Refinancing
Refinancing a home equity loan is similar to refinancing a first mortgage, which was used to purchase the home. Lenders will assess your eligibility based on your income, expenses, debts, and home’s value. You must present pay stubs, W-2 forms, bank statements, and tax returns to verify your ability to repay the loan you’re requesting (or temporarily provide lenders safe access to your online accounts).
You will also be responsible for the cost of a full house appraisal, a drive-by evaluation, or an automated valuation model (AVM) appraisal. The lender will determine your home’s equity based on its evaluated worth.
If your FICO score falls between 740 and 850, which is considered “very good” or “outstanding,” you will be eligible for the lowest interest rates. You may still be eligible to refinance your home equity loan with a score as low as 620, but you will pay a higher interest rate and may be required to borrow less than if your score were higher. You may also discover that the accessible pool of lenders is somewhat limited.
Lenders will also determine if the sum of your present monthly debt payments plus the proposed monthly loan payment exceeds fifty percent of your gross monthly income. This is referred to as the debt-to-income ratio (DTI). Some lenders have lower restrictions, such as 43%, and you may not qualify with a DTI this high unless all other areas of your finances are solid.
Refinancing of a Home Equity Loan Example
Consider a home with a value of $250,000, a primary mortgage balance of $165,000, and a home equity loan balance of $25,000. You have borrowed a total of $190,000 against the equity in your residence. To calculate CLTV, divide $190,000 by $250,000. 76% is the consequence, making your home equity 24%.
If you borrow against less equity, your interest rate will be lower. Some lenders may require a CLTV of no more than 60% or 70% to qualify for the lowest interest rate.
How it Works for Tip 1: Refinance into a New Home Equity Loan
You can replace your existing home equity loan with one of the same size or a bigger amount if you have sufficient equity. You will acquire a new interest rate and loan term.
Pros
With a lower interest rate and/or a longer loan period, you may be able to reduce your monthly payment or borrow more without a substantial increase in the total cost. Unless you pay off your home equity loan within the first 36 months, many lenders will cover the majority or all of your closing fees. In such a scenario, you may be required to reimburse the lender for a proportionate share of the closing fees it incurred on your behalf.
Cons
Even if you are receiving a cheaper rate, extending your loan term may cause you to pay more interest over time. If your financial situation deteriorates, the chance of losing your house increases if you take out a larger loan.
Tip 2: Refinance Into a Home Equity Line of Credit (HELOC)
How It Operates
A home equity line of credit (HELOC) can be used to pay off a home equity loan.
Pros
Throughout the draw period of a HELOC, which is normally 10 years, you will often have the option to make interest-only payments. Refinancing your home equity loan with a home equity line of credit could significantly reduce your monthly payments.
Cons
House equity loans normally have set interest rates, whereas home equity lines of credit have variable rates. Consequently, you will exchange a known monthly payment for an uncertain one, and if interest rates rise, you may pay significantly more in the long term.
Tip 3: Refinance Into a New First Mortgage
How It Operates
Instead of refinancing simply your home equity loan and continuing to have two mortgages, you can refinance both your home equity loan and your primary mortgage into a single loan without raising the total amount you are borrowing. You will have a new loan term and interest rate. Consider it a combination of debt consolidation and rate-and-term refinancing.
Pros
First-mortgage interest rates are often lower than home equity loan interest rates, so you may save money. If you refinance into a fixed-rate mortgage, your monthly payment will be constant and your borrowing expenses will be predictable.
Cons
If the interest rate on your current first mortgage is lower than what lenders are now offering, this alternative will not make financial sense. Even if you may obtain a lower interest rate through refinancing, the closing fees on a first mortgage can be much higher, ranging from 2 to 5 percent of the loan amount. Contrast this with the fact that many lenders will cover your closing fees on a HELOC or home equity loan.
Should I utilize a cash-out refinance to repay my home equity loan?
If you wish to refinance your first mortgage and borrow additional money, a cash-out refinance could be a suitable method to refinance your home equity loan. Cash-out refinances typically have better interest rates than home equity loans, but not as good as rate-and-term refinances. In any event, the interest rate will be determined by your combined loan-to-value (CLTV) ratio and creditworthiness.
Be cautious about raising your mortgage balance. If you lose your job, receive a wage cut, or have to work less due to a significant illness or handicap, would you be able to afford the monthly payments? If you get too far behind on payments, you risk losing your house to foreclosure.
| Home Equity Loan | HELOC | Cash Out |
| A 2nd Mortage | Line Of Credit (Second Mortage) | Required refinance of current loan |
| That could be advantageous if mortgage rates reduced. | Obtainable behind your primary mortgage. | Obtainable behind your primary mortgage. |
| A single loan that can be fixed for 30 years. | only variable interest rate connected to prime | That could be advantageous if mortgage rates reduced. |
Does it make sense to consolidate my first mortgage and home equity loan despite the closing costs?
You’ll need to calculate your breakeven time and determine how many months you’ll need the new loan to break even after paying closing fees. The better the breakeven period, the shorter it is.
Your lender may permit you to finance your closing expenses, mitigating the immediate impact of this increased expense. Nevertheless, if you include closing fees in your loan, you will pay interest on them for many years.
Paying a higher interest rate is an alternative to paying closing expenses. While you are likely seeking a cheaper rate by refinancing, this is not the most promising method.