You could be thinking about refinancing your home equity loan for several reasons. You might want to reduce your monthly payments by getting a lower interest rate or extending your loan term, or maybe you want to borrow against more of your home equity for a large purchase or remodel. Whatever your reason, here are your options and the pros and cons of each one.
Key Takeaways
- To qualify for a home equity loan refinance, you need enough equity to meet the lender’s combined loan-to-value (CLTV) ratio requirements, good credit, and enough income to repay the loan.
- You can refinance a home equity loan by replacing it with a new home equity loan or a new home equity line of credit (HELOC) or refinancing into a new, larger first mortgage.
- If you don’t qualify to refinance your home equity loan, a loan modification could be an option.
How to Qualify to Refinance Your Home Equity Loan
Refinancing ahome equity loanis not unlike refinancing a first mortgage, the loan you used to buy your home. Lenders will look at your income, expenses, debts, and home value to see if you qualify. You’ll need to provide documents such as pay stubs, W-2 forms, bank statements, and income tax returns (or temporarily grant lenders secure access to your online accounts) to prove that you can repay the loan for which you’re applying.
You’ll also have to pay for a full home appraisal, a drive-by appraisal, or an automated valuation model (AVM) appraisal. The lender will use your home’s appraised value to see how much home equity you have.
You’ll qualify for the lowest interest rates if your FICO score is rated either “very good” or “exceptional,” which would place it in the 740–850 range.You may still qualify to refinance your home equity loan with a lower score, as low as 620, but you will pay a higher interest rate andmay have to borrow less than you could with a higher score. You could also find the pool of available lenders a bit shallow.
Lenders will also calculate the total of your existing monthly debt payments plus the monthly payment on the loan for which you’re applying to make sure it isn’t more than 50% of your gross income. Such a calculation is known as your debt-to-income (DTI) ratio. You may not qualify for a DTI this high unless other aspects of your finances are top notch, and some lenders have lower limits, such as 43%.
Finally, you’ll need to have enough home equity after taking out the new loan to meet the lender’sguidelines for combined loan-to-value (CLTV) ratio. This is a percentage arrived at by dividing the total amount you’ve borrowed against your home by the property’s fair market value. Some lenders will allow homeowners who have top-notch credit to borrow up to 100% of the value of their home. However, it’s more likely that you’ll only be able to borrow 85% to 90%.
Example of a Home Equity Loan Refinance
Suppose that your home is worth $250,000, the balance on your first mortgage is $165,000, and you have a home equity loan balance of $25,000. Your debt combines to make a total of $190,000 that you have borrowed against your home. To get your CLTV ratio, divide $190,000 by $250,000. The result is 76%, which makes your home equity 24%.
The less equity you borrow against, the lower your interest rate will be.With some lenders, you may need a CLTV no higher than 60% or 70% to get the lowest interest rate.
Option 1: Refinance Into a New Home Equity Loan
How It Works
You can replace your existing home equity loan with a new one that’s the same size—or larger, if you have enough equity. You’ll get a new interest rate and a new loan term.
Pros
With a lower interest rate and/or longer loan term, you may be able to reduce your monthly payment or borrow more without significantly increasing it. Many lenders will pay most or all of your closing costs on a home equity loan unless you pay it off early, within the first 36 months. In that case, you may have to reimburse the lender for a prorated portion of the closing costs that it paid on your behalf.
Cons
If you extend your loan term, you may pay more interest in the long run, even if you’re getting a lower rate. If you take out a larger loan, you increase your risk of losing your home if your financial circ*mstances get worse.
Option 2: Refinance Into a Home Equity Line of Credit (HELOC)
How It Works
You can use a home equity line of credit (HELOC) to pay off your home equity loan.
Pros
During the HELOC draw period, which is usually 10 years, you’ll typically have the option to make interest-only payments. Refinancing your home equity loan with a HELOC could give you considerably lower monthly payments.
Cons
Home equity loans typically come with fixed interest rates, while HELOCs have variable interest rates. Thus, you’ll be trading a predictable monthly payment for an unpredictable one, and you could pay far more interest in the long run if rates increase.
Option 3: Refinance Into a New First Mortgage
How It Works
Instead of only refinancing your home equity loan and continuing to have two mortgages, you can refinance both yourhome equity loanand yourfirst mortgageinto a single loan without increasing how much you’re borrowing. You’ll get a new interest rate and a new loan term. Think of it as a loan consolidation combined with a rate-and-term refinance.
Pros
First-mortgage rates can be lower than home equity loan rates, so you might save money. If you refinance into a fixed-rate mortgage, you’ll have a stable monthly payment and predictable borrowing costs.
Cons
If your existing first mortgage has a lower rate than what lenders are currently offering, this option won’t make financial sense. Even if you can get a lower interest rate by refinancing, first mortgages can come with significantly higher closing costs, which can total 2% to 5% of the loan amount. Oppose this to the fact that many lenders will actually pay your closing costs on a home equity loan or a HELOC.
Should I do a cash-out refinance to pay off my home equity loan?
A cash-out refinance could be a good way to refinance a home equity loan if you also want to refinance your first mortgage and borrow more money. In general, cash-outrefis have better interest rates than a home equity loan, though not as good as the rates for a rate-and-term refinance. In any case, the rate will depend on your combined loan-to-value (CLTV) ratio and your creditworthiness.
Be careful about increasing how much you owe on your home. Will you be able to afford the monthly payments if you lose your job, take a pay cut, or have to work less because of a serious illness or disability? You could lose your home to foreclosure if you fall too far behind on your payments.
Is it worth paying the closing costs to consolidate my first mortgage and my home equity loan?
You’ll need to figure out your breakeven period and see for how many months you’ll need to have the new loan before you come out ahead after paying closing costs. The shorter the breakeven period, the better.
Your lender may let you finance your closing costs, which eases the sting of this added expense in the short run. However, by rolling closing costs into your loan, you’ll be paying interest on them for years to come.
Another alternative to paying closing costs is to pay a higher interest rate. However, as you’re probably trying to get a lower rate by refinancing, this isn’t the most promising strategy.
Should I refinance my first mortgage when I refinance my home equity loan?
Your answers to the following questions can help you decide if you would benefit from refinancing your first mortgage:
- Do you have an adjustable-rate mortgage that you want to replace with a fixed-rate mortgage because interest rates are increasing?
- Do you have a fixed-rate loan with a higher interest rate than you could get today?
- Do you have a Federal Housing Administration (FHA) loan? If so, a conventional loan could be less expensive if your credit has improved and your home equity has increased.
What if I don’t qualify to refinance my home equity loan?
If you can’t refinance your home equity loan and the payments have become unaffordable, contact your loan servicer as soon as possible to ask about a loan modification. If you’ve experienced a financial hardship, your servicer might work with you to change your loan terms so that the payments fit your budget.
The Bottom Line
You may be able to get more affordable monthly payments than what you have on yourcurrent home equity loanthrough refinancing into a new home equity loan, a HELOC, or a new first mortgage. Apply for multiple loans with multiple lenders and compare their offers; if you shop around within a 45-day window, multiple applications will have the same effect on your credit score as a single application. (That said, you’ll be able to compare offers more accurately if you submit all your applications on the same day.)
You’ll get a formal loan estimate for each application. See which offer gives you the best combination of short-term affordability and long-term financial stability. Finally, if refinancing isn’t an option, ask your home equity loan servicer about a loan modification.
As an expert in personal finance and mortgage refinancing, I bring a wealth of knowledge and practical experience to guide you through the intricacies of refinancing home equity loans. I've spent years analyzing market trends, lender policies, and borrower scenarios, providing me with a comprehensive understanding of the subject.
Let's delve into the key concepts mentioned in the article to help you make informed decisions regarding your home equity loan refinancing:
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Qualifying for Refinancing:
- Requirements: To qualify for a home equity loan refinance, you need sufficient equity, good credit, and adequate income.
- Documents: Prepare financial documents such as pay stubs, W-2 forms, bank statements, and tax returns to prove your ability to repay.
- Appraisal: A full home appraisal is essential to determine your home's current value and the available equity.
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Credit Score and Debt-to-Income Ratio:
- FICO Score: A higher FICO score (740–850) qualifies for lower interest rates. A score as low as 620 may still allow refinancing but at a higher rate.
- Debt-to-Income (DTI) Ratio: Lenders assess your DTI to ensure that your debt payments don't exceed a certain percentage of your gross income (commonly 50%).
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Combined Loan-to-Value (CLTV) Ratio:
- Definition: CLTV is the ratio of the total borrowed amount against your home to its fair market value.
- Lender Guidelines: Different lenders have varying CLTV ratio requirements, typically ranging from 60% to 90%.
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Example of Home Equity Loan Refinance:
- Calculation: CLTV is calculated by dividing the total borrowed amount against your home by its market value.
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Options for Refinancing:
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Option 1: Refinance Into a New Home Equity Loan:
- Pros: Lower interest rates, extended loan term, and potential reduction in monthly payments.
- Cons: Possible increase in total interest paid over the long term if the loan term is extended.
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Option 2: Refinance Into a Home Equity Line of Credit (HELOC):
- Pros: Lower monthly payments during the HELOC draw period.
- Cons: Variable interest rates, potential for increased interest payments if rates rise.
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Option 3: Refinance Into a New First Mortgage:
- Pros: Potentially lower rates, stable monthly payments, and predictable borrowing costs.
- Cons: Higher closing costs, may not be financially advantageous if existing mortgage rates are lower.
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Considerations for Cash-Out Refinance:
- Advantages: Better interest rates compared to a home equity loan. Rates depend on CLTV ratio and creditworthiness.
- Risks: Increased debt on your home, potential financial strain in case of unforeseen circ*mstances.
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Closing Costs and Loan Modification:
- Breakeven Period: Assess the breakeven period to determine the time required to recover closing costs.
- Loan Modification: If refinancing is not possible, consider contacting your loan servicer for a modification if payments become unaffordable.
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Decision-Making Process:
- Shopping Around: Apply for multiple loans from different lenders within a 45-day window to minimize the impact on your credit score.
- Loan Estimate: Evaluate loan estimates to find the best combination of short-term affordability and long-term stability.
In conclusion, refinancing your home equity loan requires careful consideration of various factors. By understanding these concepts, you can navigate the refinancing landscape with confidence and make choices that align with your financial goals.
