Refinancing a home equity loan: When and how to do it

You’ve probably heard plenty about refinancing your mortgage for better terms. But what about your home equity loan? Since it is essentially a second mortgage, can you refinance it too?

The short answer: Yes. You might be able to refinance a home equity loan as you would your primary mortgage. Doing so can help you secure a lower interest rate, adjust the repayment term, or tap additional funds from your home’s increased value.

But you’ll have to have a big enough outright-ownership stake, and meet some other qualifications as well. Here is  everything you need to know about when and how to refinance a home equity loan.

How to refinance a home equity loan

Refinancing a home equity loan (HELoan) basically involves replacing your existing loan with a new one.

Steps to refinancing your home equity loan

1. Assess your position: It starts with determining whether refinancing benefits you. Look at the current interest rates compared to what you have, calculate potential savings over time, and consider how long you plan to stay in the home. You want it to be long enough to “break even” – that is, have the savings outweigh the costs you’ll pay upfront to refinance.
2. Equity check: Calculate your current equity stake. If your home’s value has increased, for instance, from $350,000 to $400,000, and you have paid down your mortgage and previous home equity loan to a total outstanding amount of $200,000, you have $200,000 or a 50 percent equity stake — enough to consider refinancing.
3. Credit score review: Check your credit score, as it impacts your  interest rate offers — or whether you’ll qualify for the refi at all. For example, raising your credit score from 670 to 740 might drop your rate by a whole percentage point.
4. Shop for lenders: Reach out to several lenders to find the most favorable rates and terms. For example, one lender might offer a 4.5 percent interest rate with no closing costs, while another could offer 4.25 percent with closing costs. You’d want to choose the latter.
5. Understand the costs: Know the associated expenses of refinancing. These include application fees or an early payoff penalty on your existing loan. For example, if your lender charges a 2 percent prepayment penalty on your $20,000 home equity loan, you’ll owe $400.
6. Decide on type of refi: Based on your goals, decide if another fixed-rate home equity loan, a variable home equity line of credit (HELOC), or a cash-out refinance works best for you. A HELOC might offer a good option if you prefer to access your equity on a rolling basis rather than a lump sum. A cash-out refi would probably offer a lower interest rate, but it does involve replacing your current mortgage.
7. Do the application: Apply for the new loan, supplying proof of your income, assets and debts. Depending on the lender’s requirements, a new property appraisal may be needed to assess your home’s current value.
8. Review offers: When you get offers, compare the details, being sure to look at the annual percentage rates (APRs )—since they include fees, APRs give a truer sense of the total cost of the loan. If you’re going for a HELOC, be sure you understand how often rates will fluctuate and by how much per year.
9. Close the loan: At closing, settle any upfront costs. Use the new loan to pay off your existing home equity loan. Then, start repaying it according to the fresh terms.

How to qualify to refinance a home equity loan

Having a home equity loan doesn’t automatically make you eligible for a refinance. You must qualify.

The first requirement for a home equity loan is that your home serves as adequate collateral to secure the loan. Most lenders require you to have a combined loan-to-value (CLTV) ratio of no more than 85 percent, meaning the sum of all your outstanding home-backed debts (primary mortgage, home equity loan) makes up no more than 85 percent of your home’s total value. In other words, you own at least 15 percent of your home free and clear.

While you’ll have already met this benchmark when you first got your home equity loan, you’ll have to revisit it if you want to refinance — it’s possible your home’s value dropped since you first took out the loan.

This isn’t a common situation, but it can happen if the local residential real estate market has softened significantly, reducing your home’s resale price. It may also happen if your home equity loan was a sizable one, depleting your  good chunk of equity out of the home recently, and you haven’t repaid much of it yet.

You also need to meet personal financial and credit requirements. Many lenders require a 620 minimum for refinances in general. Standards for home equity loans tend to be tougher, though, because these second mortgages fall behind primary mortgages in the pecking order of creditor repayment, should you default. Some HE lenders have loosened their standards of late. But a “good” score, preferably above 700, remains the threshold for many institutions. Even among lenders who work with “bad credit” candidates, the minimum score averages around 640.

You also must have sufficient income to make payments on the loan and a low debt-to-income ratio (DTI) — that is, the monthly bills you pay should generally comprise no more than 43 percent of your monthly gross income.

Finally, you should have a good repayment record with the current home equity loan — especially if you want to refinance with the same lender. It may be hesitant if you’ve missed payments, been late or fallen short. Conversely, if your financials are a little weak but your record is solid, it may cut you some slack, given you’ve been a reliable borrower as far as its loan is concerned.

Reasons to refinance a HELoan

There are several good reasons to refinance your existing home equity loan. They include:

• Reducing your monthly payment. Often, refinancing your home equity loan will result in having to pay less each month. This happens in one of two ways: You score a better (i.e., lower) interest rate on the new loan, or the new loan has a longer term.
• Locking in a lower interest rate. Many people refinance their home equity loans because interest rates have significantly dropped. Locking in a more favorable interest rate can significantly lower monthly payments and of course the amount of interest you pay overall.
• Switching from an adjustable to a fixed rate. If your home equity loan currently carries a variable rate, switching to a fixed-rate loan offers more stability. You will have a predictable payment each month instead of one that fluctuates with interest rate trends. Conversely, you may want to ditch a loan with a high fixed rate in favor of a variable rate if interest rates are on a long-term downward course.
• Borrowing additional home renovation funds. Homeowners taking on a major repair (non-functioning furnace, damaged roof ) or remodel often find home equity loans the most affordable way to fund these five-figure projects. If you’ve got a job running above budget, or you’ve augmented it somehow, a refinance could get you help with the same potential tax benefits and lower costs.
• Customizing terms. If you have a 15-year repayment term on your home equity loan with 10 years left, refinancing gives you the opportunity to change those terms. You can either shorten the term to pay it off more aggressively or lengthen it to allow yourself more time to complete the loan.

Can you refinance an existing mortgage with a home equity loan?

No. Your home equity loan is a second mortgage that allows you to borrow against your home’s equity. It can’t replace your first mortgage. If you want to refinance your home’s existing mortgage while tapping into its equity, a cash-out refinance is something to explore.

Pros and cons of refinancing a home equity loan

Pros

The benefits to refinancing a home equity loan include:

• Lower monthly payments: All else being equal, if you can get a lower interest rate, you’ll save on your monthly payments and interest overall.
• Shortened or stretched term: Transitioning to a longer term, such as 10 years instead of five, will decrease your monthly payment but also add to your interest charges. Alternatively, you might opt for a shorter loan term, which raises your monthly payments but allows you to pay off the debt faster, saving you on interest and freeing up room in your monthly budget sooner.
• Better rate: If your home equity loan has a fluctuating rate, or you have a HELOC or a HELoan with a fluctuating rate (the latter are rare, but do exist) you can refinance to a fixed-rate vehicle. Or, if your loan is a high fixed rate, refinancing to an adjustable rate can allow you to benefit if interest rates drop.
• Additional cash: Assuming your equity stake has increased, you can refinance into a bigger loan.

Cons

The drawbacks to refinancing a home equity loan include:

• Prepayment penalty: Depending on the type of home equity loan and your lender’s policy, you might be subject to a fee if you pay it off early (which is what refinancing does) or before a specific time frame.
• Repayment risks: If you can’t keep up with the payments on the new loan (say you converted to a shorter-term loan with a higher monthly payment), you open yourself up to the possibility of foreclosure.
• At the mercy of the market: If your home declines in value, you could wind up being underwater — that is, owing more between your mortgage and home equity loan than the home is worth. If the real estate market has already softened, you might not be able to refinance at all.
• Longer debt: Refinancing your home equity loan will reset the repayment term. Unless you specifically choose a shorter loan, it will extend the debt. If you sell the home, it could mean a bigger bite into your proceeds, as you’ll have to pay off the home equity loan immediately.

Can you refinance a home equity loan into a HELOC?

Yes, you can refinance a home equity loan into a home equity line of credit (HELOC), but weighing the potential benefits against the drawbacks is vital.

Benefits of refinancing into a HELOC

• Potential for lower interest rates: If market interest rates have fallen since taking out your original loan, switching to a HELOC could help you secure a lower rate, reducing overall interest costs. And you’d benefit from additional declines throughout the HELOC’s term, as your rate would adjust with the market.
• Flexibility: Unlike the lump-sum payout of a home equity loan, a HELOC provides you with a revolving line of credit. This allows you to tap into funds as and when you need them, offering enhanced financial flexibility. And you only incur interest on funds you’ve actually borrowed.

Downsides to refinancing into a HELOC

• Variable interest rates: A HELOC’s variable rate nature means your rate fluctuates over time. While this could lead to lower payments if rates drop, it could also result in higher payments if rates increase.
• Higher interest rates: The ratio varies, but for the last few years, HELOC rates have been as much as a full percentage point higher than home equity loan rates.
• Extra costs: Some HELOCs charge a transaction fee each time you withdraw, and others charge inactivity fees. Many also come with annual maintenance fees. While small, these could eat into your savings from lower rates.
• Harder to qualify: Lenders want to be sure you can handle fluctuating payments, so their HELOCs may have more stringent requirements. For example, online lender Spring EQ sets a minimum credit score of 680 for its HELOC, but only 620 for a home equity loan.

Can you refinance a home equity loan and your mortgage at the same time?

Yes, it is possible to refinance both a home equity loan and your primary mortgage simultaneously. A typical way to do it is through a cash-out refinance, which entails taking out a larger mortgage than your current one, getting the difference in ready money. In this case, you can use the surplus funds to pay off your home equity loan.

Advantages of refinancing both loans simultaneously

• Debt consolidation: This option allows you to combine your primary mortgage and home equity loan into a single payment, simplifying your financial management and potentially offering a lower overall interest rate than standard home equity loan (refis tend to run a percentage point or two cheaper).
• Access to cash: The “cash-out” part of a cash-out refinance means you end up with additional funds. If there’s anything left after paying off the home equity loan, you could use the cash for various expenses like home improvements, credit card bills or tuition.

Drawbacks to refinancing both loans simultaneously

• Potential for higher interest rate: Cash-out refinances often attract higher interest rates than standard rate-and-term refinances, which could lead to increased costs over the life of the mortgage. Also, the prevailing interest rate may be higher than that on your current mortgage.
• Increased loan amount and duration: You’ll essentially be taking out a larger loan, and extending your repayment period. This might lead to higher total interest payments, especially if you don’t plan on accelerating your payments to compensate for the reset amortization schedule.

What if you don’t qualify for a home equity loan refinance?

If you find yourself unable to refinance your home equity loan, consider exploring these alternative paths to paying it off. Basically, these options involve exchanging one obligation for another.

1. Home equity sharing agreements: These agreements, which give you a lump sum, often have more lenient criteria, potentially suitable for those with lower credit scores or other weak financials. Technically, the money you receive is an investment in your home, not a loan: Instead of receiving regular monthly payments, the investing company takes a share of your home’s future value when you sell it or at the end of a specified period. However, if your home appreciates significantly, this could end up being more costly than traditional loan interest payments.
2. Reverse mortgages: Seniors (those aged 62 and up) can tap into their home equity by taking out these mortgages without monthly payments; instead, the loan is repaid when the home is sold or the borrower permanently vacates it. However, note that interest accrues on mortgage balance over time, which can substantially increase the amount owed in the long run.
3. Personal loans: Unsecured personal loans can provide fast cash for emergencies or other needs. These loans generally carry higher interest rates than those secured by your home and shorter terms; they may have additional fees, as well.

Bottom line on home equity loan refinances

As with a regular mortgage refinance, you have to apply for a refinance of your home equity loan, either with the current lender or another one. Be prepared to provide credit and financial information to the lender, along with a list of assets and liabilities.

In many ways, it’s similar to the first time around — though often, refinancing a HELoan is easier, given that you’ll probably be applying for a smaller sum and likely have a good track record repaying the first debt. Still, you’ll want your financial profile to look as strong as possible.

The best reason to refinance a home equity loan is if interest rates have dropped since you borrowed the first time. Just be sure to consider your timeline for staying in the home, be aware of any change in your home value, and take into account any fees you might incur, like closing costs.

Additional reporting by Ashlee Tilford