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.
How can you refinance a home equity loan? In this article, we’ll go over the reasons to refinance with home equity loans, how to refinance and possible drawbacks. We’ll also explain other financing options for utilizing your home equity, such as a cash-out refinance.
Key Takeaways:
- Refinancing a home equity loan can be a way to fund new projects, lower your monthly payment and secure better loan terms.
- Before committing, calculate your equity and determine whether prepayment penalties, closing costs and other fees outweigh the potential savings.
- If refinancing your home equity loan isn’t viable, an equity-sharing agreement, reverse mortgage or personal loan may be a good choice.
What Is A Home Equity Loan?
Home equity loans are second mortgages you can use to tap into your existing home equity. Your home equity is the portion of your home’s value you’ve already paid for through your mortgage.
Many people are understandably confused about the difference between a second mortgage and a home equity loan. The two terms are related, but they aren’t identical:
- A second mortgage is a loan using a home with an existing mortgage as collateral.
- A home equity loan is a type of second mortgage (the other type being a home equity line of credit, or HELOC).
Refinancing with a home equity loan can be a low-interest way to build a pool, consolidate your debt or remodel your home. Because home equity loans are secured by your home, they almost always have lower interest rates than personal loans, credit cards and other kinds of unsecured debt.
However, you should carefully assess your ability to repay before committing. Because your home serves as collateral, the lender can foreclose on it if you fail to pay.
If you meet your lender’s home equity loan requirements and it 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.Before you apply, it’s a good idea to familiarize yourself with the advantages and disadvantages of home equity loans. It’s easy to get drawn in by the low interest rate, but refinancing this way isn’t free.
Closing costs for home equity loans usually include the loan origination fee, filing fee, appraisal fee and title search fee. In total, closing costs are typically between 2% and 5% of the loan’s value. If you were to take out a $100,000 home equity loan, your closing costs would probably be between $2,000 and $5,000.
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What Are The Advantages and Disadvantages Of Refinancing A Home Equity Loan?
Most people who refinance with home equity loans tend to find that the benefits outweigh the drawbacks. However, these loans may not be right for everyone. If you’re considering a home equity loan, you should first calculate your equity and take a look at some of the main pros and cons.
Advantages
There are many reasons you might choose to refinance a home equity loan. Let’s take a look at some of the most common reasons below.
- Lower monthly payments: You could lower your mortgage payments by getting a lower interest rate (more on that below) or taking a longer loan term in exchange for smaller monthly payments.
- Lower interest rates: 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.
- Shorter loan terms: If you shorten your mortgage term, you can save a considerable amount on interest.
- Switch between adjustable- and fixed-rate loans: Home equity loans can be fixed or adjustable. Changing your loan type might help you save money in the long term. Adjustable-rate mortgages (ARMs) may have lower initial rates that might adjust up or down depending on the market movement. Fixed-rate mortgages have consistent monthly payments, but your interest rate is determined when you get your mortgage and won’t change with the market.
- 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 and more.
Disadvantages
As with any loan, risks are involved when attempting to refinance a home equity loan. Let’s run through some of those drawbacks:
- You risk foreclosure if you don’t pay on time: 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.
- Your home’s value may fluctuate: If your home value drops sufficiently, you may find you have a hard time selling your house for what you owe on your combined mortgages. Alternatively, you may not be able to refinance your first mortgage.
- Your credit score: If your credit has had some dings since you initially financed your home equity loan, your application could be denied.
- Closing costs can be expensive: Home equity loan closing costs are usually between 2% and 5% of the loan’s total value.
- Debt-to-income ratio requirements can be stringent: Most lenders will want you to have a debt-to-income ratio of 43% or less.
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How To Refinance A Home Equity Loan
You might wonder: How can you refinance a home equity loan? The process for refinancing a home equity loan is very similar to the initial loan application process. Let’s take a look at the details of how to refinance a home equity loan below.
1. Review Your Credit Score And Debt-To-Income Ratio (DTI)
If you want to refinance a home equity loan, it will help to have a median FICO® Score in the high 600s. You’ll also want to keep a fairly low debt-to-income ratio (DTI) and save up for closing costs.
You can access your free annual credit report online. To find your median score, look at your credit scores from all three credit bureaus: Experian, Equifax and TransUnion. When you order these scores from lowest to highest, your median score is the one in the middle.
Calculating your monthly DTI is simpler than it sounds. Here’s how to do it:
- Add up your mortgage, car loan, credit card and other monthly debt payments.
- Find your gross monthly income (income before taxes and deductions).
- Divide monthly debt payments by monthly gross income.
- Multiply by 100.
For example, let’s say your monthly debt payments come out to $2,000 and your gross income is $6,000 per month. In this case, your DTI is about 33%. Most lenders want you to have a DTI no greater than 35% – 43%, so this value puts you in the clear.
2. Check Your Home Equity
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. You’ll also want to check lender requirements before applying.
To check your home equity, you’ll need to take a few simple steps:
- Determine your home’s current value.
- Find the outstanding balance on your mortgage.
- Subtract the outstanding balance from your home’s market value.
For example, imagine that your home is currently worth $500,000. You still owe $200,000 on your mortgage, so your equity is $300,000.
You can get an estimate of your home’s market value online to get a general idea of your current equity. Before you’re approved for a home equity loan, however, your lender will probably require a professional appraisal.
3. Assess Your Combined Loan-To-Value Ratio (CLTV)
Your lender will determine your combined loan-to-value ratio (CLTV), which is similar to your loan-to-value ratio (LTV). Your LTV compares the amount you currently owe on your loan to the appraised value of your home and is expressed as a percentage. For CLTV, instead of 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 using your property as collateral. Most lenders require a CLTV of under 85% to secure a loan or refinance.
4. Research Loans And Lenders
Before you commit to a refinance, make sure to shop around and compare loans to get the best interest rate and repayment terms. Talk to your original lender about refinancing, especially if you are happy with your current lender. Your existing lender may consider waiving fees to retain your business. That said, shopping around will help you explore all of your options to make the best choice for your situation.
5. Submit An Application
Once you’ve settled on a lender, submit your application either online or in person. Before you sit down to complete an application, make sure you gather all necessary documentation:
- Proof of identity
- Proof of income (like W-2s or federal tax returns)
- Your home title and title insurance policy
- Your existing mortgage documentation
- Your homeowners insurance declaration
- Your property tax statement
If you’re planning to submit multiple loan applications with different lenders, try to limit your submission window to a few days. This helps minimize the period during which lenders will perform hard credit checks and reduces the negative impacts on your credit score.
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Alternatives To Refinancing A Home Equity Loan
How can you refinance a home equity loan? There are a few different answers, but these loans may not be right in every circumstance. Although refinancing a home equity loan can be a great option for some, in some circumstances, other paths to changing your rate, term or the loan itself could be worth pursuing.
Here are a few alternatives to home equity loans to consider:
Home Equity Loan Modification
If you’re having significant trouble paying off your loan, you may be able to talk with your lender about modifying the terms of the loan without a refinance. Typically, no fees will be associated, unlike with a refinance, but there will likely be requirements you have to meet.
Additional Payments
You’ll need to check the terms of your home equity loan, but you might be able to reduce your principal and pay down your loan sooner by making additional payments on your loan.
A Cash-Out Refi To Consolidate
A cash-out refinance involves replacing your current mortgage with a new primary mortgage. With this option, instead of having both a first and a second mortgage, as you might with a home equity loan, you’ll consolidate your debt into one monthly payment. A cash-out refinance still utilizes your equity, but it can have a couple of advantages over a home equity loan or HELOC.
- Lower interest rates: A cash-out refinance offers lower interest rates for borrowers since it serves as a primary mortgage versus a secondary mortgage. This is key for lenders because when your home is sold, the primary mortgage is first in line for repayment. Since this minimizes risk for lenders, you’re likely to get a lower interest rate in return.
- One monthly payment: If you have two separate loans, you’ll need to make two separate monthly payments – one for your primary mortgage and one for your secondary mortgage – like a home equity loan or HELOC. If you consolidate your loans with a cash-out refinance, you’ll make only one payment on your new primary mortgage.
However, cash-out refinancing comes with some downsides, too. Although it offers instant cash and lower interest rates, it can also lead to longer loan terms and higher monthly payments, which ultimately result in paying more interest over time.
The Bottom Line: There Are Multiple Options
There are 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. If you want to refinance, keep in mind you ’ll need to maintain a relatively high credit score to qualify for the best rates on a new loan.
No matter why you want to refinance your home equity loan, it’s important to pick the right loan option for you. A qualified financial adviser can help you choose the best option for your financial goals.
Ben Shapiro
Ben Shapiro is an award-winning financial analyst with nearly a decade of experience working in corporate finance in big banks, small-to-medium-size businesses, and mortgage finance. His expertise includes strategic application of macroeconomic analysis, financial data analysis, financial forecasting and strategic scenario planning. For the past four years, he has focused on the mortgage industry, applying economics to forecasting and strategic decision-making at Quicken Loans. Ben earned a bachelor’s degree in business with a minor in economics from California State University, Northridge, graduating cum laude and with honors. He also served as an officer in an allied military for five years, responsible for the welfare of 300 soldiers and eight direct reports before age 25.
