Can You Refinance A Home Equity Loan?
A home is a place to sleep, entertain and generally enjoy life, but it’s also an investment in which you build up equity. Think of home equity as the difference between what you owe on your home and its market value. To accomplish your financial goals, you can turn your equity into cash by taking out a loan or line of credit based on a portion of your existing equity.
At some point, you may want to refinance your home equity loan. In this article, we’ll go over the reasons for refinancing your home equity loan, how to refinance and discuss the drawbacks to refinancing. We’ll also explain other financing options for utilizing your home equity, such as a cash-out refinance.
What Is A Home Equity Loan?
Home equity loans are second mortgages you can use to tap into your existing home equity. If your lender approves you for the amount you’ve requested, you’ll receive an upfront lump sum at a fixed interest rate, which you’ll repay over a fixed repayment term for the life of the loan or until you’ve paid off the mortgage loan balance.
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Reasons To Refinance A Home Equity Loan
Your decision to refinance a home equity loan comes down to the same reason you would look for better options for car or student loan financing.
- Lower monthly payments: You could end up with lower mortgage payments by either getting a lower interest rate (more on that below) or taking a longer loan term in exchange for smaller payments.
- Secure a lower interest rate: The major benefit of a lower mortgage rate is that you pay less interest over the life of the loan. The payments themselves may be bigger or smaller depending on the term of the loan.
- Switch between adjustable and fixed-rate loans: Home equity loans can be either fixed or adjustable. Adjustable-rate mortgages (ARMs) tend to have lower teaser rates for the first part of the term – though not always. The trade-off is that they can adjust up or down in the future with market movement. On the other hand, fixed-rate mortgages provide more payment certainty.
- More borrowing power: As a homeowner, you can utilize a home equity loan to borrow more money for home improvement projects, boost savings in a college or retirement fund, consolidate high-interest debt, make a large purchase or use the money in a number of other ways.
How To Refinance A Home Equity Loan
If you want to refinance a home equity loan, it will help to have a median FICO® Score of at least 680. For the best rates, you want a credit score of 700 or higher, according to Experian™. You’ll also want to keep a fairly low debt-to-income ratio (DTI)and save up for closing costs, although some lenders will waive those fees.
Another important consideration is how much home equity you have. Although some lenders may allow you to convert more equity into cash than others, you usually need to leave a certain amount of equity in the house.
Finally, your lender will determine your combined loan-to-value ratio (CLTV), which is like regular LTV except that instead of just comparing the appraised value of a property to the loan amount your lender will also add up your mortgage balance and any secured loans you’ve taken out against the collateral property. Most lenders require a CLTV of under 85%.
Cons Of Refinancing A Home Equity Loan
As with any loan, risks are involved when attempting to refinance a home equity loan. Let’s run through some of those drawbacks:
- Since home equity loans use your home as collateral, you risk losing the home if you can’t make the monthly payments for the new loan.
- If your home value drops sufficiently, you may find you have a hard time selling your home for what you owe on your combined mortgages. Alternatively, you may not be able to refinance your first mortgage.
- If your credit has had some dings since you initially financed your home equity loan, you could find that your application to refinance is denied.
Alternatives To Refinancing A Home Equity Loan
While home equity loans are one option for accessing the equity in your home, they’re by no means the only one. Here are a couple of alternatives.
A home equity line of credit (HELOC) allows you to access your home equity similar to the way a home equity loan does. The difference is that a HELOC is divided into two periods: the draw period and the repayment period, It works a bit like a credit card in that it’s a revolving credit line for the first portion of the term.
- Draw period: Let’s say you have a HELOC with a 30-year term. The first 10 years are typically what’s referred to as the draw period. During that time frame, you can take as much money out of the account as you’ve been approved for. While you’re only required to make a minimum payment at this point, you can pay the funds back into the account to keep usingon other projects if you choose.
- Repayment period: Following the draw period, the existing balance freezes and the loan is fully amortized over the remainder of the term in order to pay off the loan.
In addition to being the difference between a line of credit and a fixed loan amount, the other big difference between HELOCs and home equity loans is that HELOCs tend to be ARMs with a variable rate whereas home equity loans can be ARMs or have a fixed interest rate.
HELOCs are best for people who want the flexibility to access the equity in their home for projects or investment, but they don’t have a fixed amount in mind for a specific purpose.
Rocket Mortgage® doesn’t offer HELOCs.
A cash-out refinance involves replacing your current mortgage with a new primary mortgage rather than having both a first and a second mortgage as you typically might with a home equity loan. Cash-out refinancing still operates on the same concept of utilizing your equity, but it has a couple of advantages over home equity loans and HELOCs:
- Lower interest rates: The mortgage rates on home equity loans and HELOCs tend to be higher because, as second mortgages, they’re riskier than cash-out refinances. In the event that you can’t make your payment and your home is sold to pay off your debts, the lender on your first mortgage – in this case, your cash-out refinance – has a first lien position, which means they would get paid first. Lenders on any secondary mortgages – such as home equity loans or HELOCs – are paid if any funds are left over after the first lender gets their cut.
- One monthly payment: As opposed to making a payment on both your primary mortgage and a secondary home equity loan or HELOC, you only have to worry about one payment when you refinance your primary mortgage.
Cash-out refinance is a common option when looking to refinance for home improvement. To qualify for a cash-out refinance, you typically have to leave at least 20% equity in your home. The exception to this is VA loans where you can take out up to the full amount of your existing equity if you have a median credit score of 620 or higher at Rocket Mortgage.
The Bottom Line
You have many reasons to consider refinancing a home equity loan including getting a lower monthly payment, securing a lower interest rate, going from a fixed rate to an ARM or vice versa, and borrowing more money. In order to refinance, you'll need to maintain a relatively high credit score.