Refinancing A Home Equity Loan: Why And How To Do It

You’ve probably heard countless times that refinancing your mortgage can help you get better terms, but what about your home loan? Since it’s essentially a second mortgage, can you refinance that too?

The short answer is, yes. Just like with a mortgage, you may be able to refinance your mortgage, which can help you lower your interest rate, adjust your repayment term, or access additional funds thanks to an increase in the value of your home.

But you still need to have sufficient title and meet other conditions. Here’s everything you need to know about when and how to refinance your mortgage.

How to refinance your mortgage

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

Steps for refinancing a home loan

1. Evaluate your position: Start by determining whether refinancing is worth it to you. Compare your current interest rate to your current one, calculate how much you’ll save over the long term, and consider how long you plan to live in your home. You want to live in it long enough to “break even” — that is, until the savings exceed the upfront costs of refinancing.
2. Equity Check: Calculate your current equity ratio: For example, if your home’s value increases from $350,000 to $400,000 and your mortgage and previous home equity loan payments total $200,000, you’ll be left with $200,000, or a 50% equity ratio, which is enough to consider refinancing.
3. Credit Score Review: Check your credit score. Your credit score affects interest rate offers and whether you qualify for refinancing. For example, improving your credit score from 670 to 740 could lower your interest rate by one percentage point.
4. Find a Lender: Contact multiple lenders to find the best rates and terms. For example, one lender might offer 4.5 percent with no fees, while another might offer 4.25 percent with fees. Choose the latter.
5. Understand the costs: Know the costs associated with refinancing, including application fees and any early repayment penalties on your existing loan. For example, if a lender charges a 2 percent prepayment penalty on a $20,000 mortgage, you’ll owe $400.
6. Determine the type of refinancing. Based on your goals, determine whether another fixed-rate mortgage, an adjustable-rate mortgage line of credit (HELOC), or a cash-out refinance is best. If you want ongoing access to your equity rather than a lump sum payment, a HELOC may be a good option. A cash-out refinance will likely have a lower interest rate, but you’ll have to replace your current mortgage.
7. Run the application: Apply for a new loan by submitting proof of your income, assets, and liabilities. Depending on the lender’s requirements, you may need a new property appraisal to assess the current value of your home.
8. Review Offer: Once you receive offers, compare the details and be sure to ask the annual percentage rate (APR). Because the APR includes fees, the APR will give you a more accurate sense of the total cost of the loan. If you take out a HELOC, be sure to understand how often your interest rate changes and how much it will fluctuate over the course of a year.
9. Pay off your loan: When you sign the contract, you pay an upfront fee. You use the new loan to pay off your existing mortgage. Then you start making payments according to the new terms.

How to qualify for a mortgage refinance

Just because you have a mortgage doesn’t mean you automatically qualify for a refinance — you have to qualify.

The first requirement for a mortgage is that your home provides enough collateral to secure the loan. Most lenders require a loan-to-value ratio (CLTV) of 85 percent or less. This means that your total home equity debt (primary mortgage, mortgage) is 85 percent or less of the home’s total value. In other words, you own at least 15 percent of your home unsecured.

You probably already met this standard when you first took out your mortgage, but if you want to refinance, you’ll need to reconsider it because the value of your home may have fallen since you first took out your loan.

This is not a common situation, but it can happen if your local residential real estate market has significantly softened and homes are selling for less. It can also happen if your mortgage is so large that you’ve recently lost a large portion of your home’s equity and still have very little to pay off.

You’ll also need to meet personal financial and credit requirements. Many lenders generally require a minimum score of 620 to refinance. However, standards for home equity loans tend to be stricter because in the event of a default, the creditor has a lower priority for repayment than a primary mortgage. Some HE lenders have recently loosened their standards. However, a “good” score of 700 or higher is still the standard for many institutions. Even among lenders who work with “bad credit” candidates, the average minimum score is around 640.

You also need to have enough income to cover your loan payments and a low debt-to-income ratio (DTI), meaning your monthly bills should generally be no more than 43% of your gross monthly income.

Finally, you need to have a good record of repaying your current mortgage, especially if you’re looking to refinance with the same lender. If you’ve had a history of missed, late, or underpayments, lenders may balk. Conversely, if your financial situation is a little weaker but your record is strong, they may be a little more lenient on you, considering you’ve been a trustworthy borrower on the loan.

Why Refinance with HELoan?

There are a number of reasons to refinance your existing mortgage, including:

• Lower your monthly payments. Refinancing your mortgage often results in a lower monthly payment. This happens in one of two ways: the interest rate on the new loan decreases (i.e. is lower), or the term of the new loan is longer.
• Lock in a lower interest rate. Many people are refinancing their mortgages because interest rates have dropped so much. Locking in a better interest rate can significantly reduce your monthly payment and, of course, your total payment.
• Switching from a floating to a fixed interest rate. If your mortgage interest rates are currently fluctuating, switching to a fixed-rate loan can offer more stability. You’ll have a predictable monthly payment, rather than payments that fluctuate based on interest rate trends. Conversely, if interest rates are trending downward over the long term, you may want to ditch a high fixed-rate loan and switch to an adjustable-rate loan.
• Additional borrowing for home improvement funds. Homeowners with major repairs (non-functioning fireplace, damaged roof) or renovations often find that a mortgage is the most affordable way to fund these five-figure projects. If you have work that exceeds your budget or you’ve increased your budget in some way, refinancing can give you the same potential tax benefits and cost-saving help.
• Customizing terminology. If your mortgage term is 15 years and you have 10 years left, you can change the terms by refinancing: You can shorten the term and make more aggressive payments, or you can extend the term and make more room to pay off your loan.

Can I refinance my existing mortgage with a home equity loan?

No. A home equity loan is a second mortgage that allows you to borrow against the equity in your home. It cannot replace a first mortgage. If you want to refinance your existing mortgage while taking advantage of the equity in your home, consider a cash-out refinance.

The pros and cons of refinancing your home loan

Strong Points

Refinancing your home loan has the following benefits:

• Low monthly payments: All else being equal, if you can get a lower interest rate, you’ll save money on your monthly payments and overall interest.
• Shortened or extended terms: Switching to a longer-term loan, such as a 10-year loan instead of a 5-year one, will lower your monthly payments but increase your interest payments. Alternatively, you could choose a shorter loan term, which will mean higher monthly payments but allow you to pay off your debt faster, saving you money on interest and filling your monthly budget sooner.
• Better Rates: If your mortgage interest rate fluctuates or you have an adjustable-rate HELOC or HELoan (the latter is rare, but they do exist), you can refinance into a fixed-rate vehicle. Or, if your loan has a high fixed rate, refinancing to a variable rate will allow you to benefit if interest rates drop.
• Extra cash: Assuming your equity ratio increases, you can refinance into a larger loan.

Cons

Disadvantages of refinancing your mortgage include:

• Prepayment Penalty: Depending on the type of mortgage and your lender’s policies, you may be charged fees if you pay off the loan early (if you’re refinancing) or before a certain period of time.
• Repayment risk: If you can’t keep up with the payments on your new loan (for example, if you change to a shorter-term loan with higher monthly payments), foreclosure increases your chances.
• At the mercy of the market: If your home’s value falls, you could end up owing more on your mortgage and home equity loan than your home is worth, putting you in default. If the real estate market is already soft, you might not be able to refinance at all.
• Long-term Debt: Refinancing your mortgage resets your repayment term, which means you’ll owe more money unless you specifically choose a shorter loan. If you ever decide to sell your home, you’ll have to pay off your mortgage right away, which could further reduce your profits.

Can I refinance my mortgage into a HELOC?

Yes, it is possible to refinance a home equity loan into a home equity line of credit (HELOC), but it’s important to weigh the potential benefits and drawbacks.

Benefits of refinancing to a HELOC

• Potential for interest rates to fall: If market interest rates have fallen since you took out your original loan, switching to a HELOC can help you secure a lower interest rate and reduce your overall interest costs, and you also have the added benefit of your interest rate decreasing even further as it adjusts with the market over the life of the HELOC.
• Flexibility: Unlike a lump sum mortgage, a HELOC gives you a revolving line of credit that allows you to draw on funds whenever you need them, giving you greater financial flexibility, and you only pay interest on the funds you actually borrow.

Disadvantages of refinancing to a HELOC

• Variable interest rate: Due to the variable rate nature of a HELOC, your interest rate will fluctuate over time. If interest rates fall, your payments may go down, but if interest rates rise, your payments may go up.
• Rising interest ratesWhile percentages vary, HELOC interest rates have been about one percentage point higher than home equity loan rates in recent years.
• Additional charges: Some HELOCs charge a transaction fee each time you make a withdrawal, others charge inactivity fees, and many also charge annual maintenance fees that, while small, can eat into the savings you’d get from a low interest rate.
• Harder to qualify: Lenders want to make sure you can accommodate fluctuating payments, so HELOCs may have stricter requirements. For example, online lender Spring EQ sets the minimum credit score for a HELOC at 680, compared with 620 for a home equity loan.

Can I refinance my home equity loan and mortgage at the same time?

Yes, it is possible to refinance both your home equity loan and your primary mortgage at the same time. A common method is a cash-out refinance, where you take out a larger mortgage than your current mortgage and receive the difference in cash. In this case, you can use the extra funds to pay off your home equity loan.

Benefits of refinancing both loans at the same time

• Debt Consolidation: This option allows you to combine your primary mortgage and home equity loan into one payment, simplifying your financial management and potentially resulting in a lower overall interest rate than a standard home equity loan (refinancing tends to be 1 to 2 percent cheaper).
• Cash Access: The “cash out” part of a cash-out refinance means that you get additional funds. If you have money left over after paying off your mortgage, you can use that cash for a variety of expenses, like home improvements, credit card payments, or tuition fees.

Disadvantages of refinancing both loans at the same time

• Potential for interest rates to riseCash-out refinances often carry higher interest rates than standard rate and term refinances, which can increase your costs over the life of your mortgage. You may also be subject to higher prevailing interest rates than your current mortgage rate.
• Increased loan amount and term: In effect, you’re taking out a larger loan and extending the repayment term, which could mean paying more in total interest, especially if you don’t plan to make payments early to make up for the reset in your repayment schedule.

What if I don’t qualify for a mortgage refinance?

If refinancing your mortgage isn’t an option, consider repayment alternatives. Essentially, these options involve exchanging one debt for another.

1. Housing property sharing agreement: These lump-sum arrangements often have more lenient criteria and may be better suited for those with low credit scores or weak financial situations. Technically, the money you receive is an investment in your home, not a loan. Rather than receiving regular monthly payments, the investment company receives a percentage of the home’s future value when you sell it or at the end of a specified term. However, if home prices rise significantly, this can end up costing you more than the interest payments on a traditional loan.
2. Reverse Mortgage: Seniors (age 62 and older) can tap into their home equity by taking out a mortgage with no monthly payments. Instead, the loan is paid off when the home is sold or the borrower moves out permanently. Keep in mind, however, that interest accrues to the mortgage balance over time, which could significantly increase the amount you borrow in the long run.
3. Personal Loans: Unsecured personal loans can give you quick access to cash for emergencies or other needs. These loans generally have higher interest rates and shorter terms than home-secured loans, and may have additional fees.

Conclusion on refinancing your mortgage

Like a regular mortgage refinance, you’ll need to apply to refinance your home equity loan with your current lender or another lender. Be prepared to provide your lender with credit and financial information, as well as a list of your assets and liabilities.

In many ways, this is similar to taking out an initial loan. However, refinancing with HELoan is easier because you’ll probably be applying for a smaller loan amount and you likely have a good repayment history on your initial loan. Still, you want your financial profile to look as strong as possible.

The best reason to refinance your mortgage is if interest rates have fallen since you first took out the loan, but be sure to consider how long you plan to stay in the home, keep an eye on changes in your home’s value, and factor in any fees you may incur, such as closing costs.

Additional reporting by Ashley Tilford