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Can You Refinance a Home Equity Loan?
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If you’ve had a home equity loan for a while and have noticed that interest rates have taken a dive since you first borrowed, you might have this question in mind: Can you refinance a home equity loan?
The answer is yes, but you’ll need to weigh whether it makes sense to move forward. This guide explains how to refinance a home equity loan and what to consider before you make the decision.
- What is a home equity loan?
- When does it make sense to refinance a home equity loan?
- How to refinance a home equity loan
- Pros and cons of a home equity loan refinance
- The bottom line
What is a home equity loan?
Home equity loans let homeowners borrow against the value of their homes, giving them a way to access the equity they’ve built to make home improvements, pay college expenses, consolidate debt or fulfill some other purpose.
The interest rate on a home equity loan is typically higher than the rate on a first mortgage, or the loan you borrowed to purchase your home. That’s because first mortgages take priority over home equity loans when debt is repaid in a foreclosure sale.
When does it make sense to refinance a home equity loan?
There are several reasons a home equity loan borrower might consider refinancing — many of which may mirror why someone would refinance a mortgage. Below, we break down when it could make sense to refinance a home equity loan or home equity line of credit (HELOC).
Reasons to refinance a home equity loan
- Your credit profile has improved. Perhaps you paid off your credit card balances and auto loan and your credit score increased, putting you in a position to grab a better interest rate and monthly payment on a new home equity loan.
- You want to change your loan terms. Maybe you want to extend your loan term to cut down on your monthly payment amount, or shorten your term to pay off your loan sooner.
- You want to lock in a lower interest rate. Average home equity loan rates are less than 6%, according to data from ValuePenguin, a LendingTree company. If your current home equity rate is significantly higher, you could benefit from a refinance.
- You want to borrow more equity. This option could work if you didn’t initially borrow the maximum amount of equity allowed or have built more equity in your home.
Costs to refinance a home equity loan
Aside from the interest you’ll pay on the amount borrowed, there are closing costs on a home equity loan, which can range from 2-5% of the loan amount. Closing costs can include:
- Loan origination fee
- Home appraisal fee
- Credit report fee
- Title search fee
- Document preparation fees
- Lawyer and notary fees
Some lenders do offer no closing cost loans, but the caveat is that you’re often required to keep your loan for at least three years. If you close the account early, you’ll have to pay for the closing costs that were waived.
How to refinance a home equity loan
Since a refinance is replacing your existing home equity loan with a brand-new loan, you can expect to meet the same eligibility guidelines as before.
You’ll need to have equity available to borrow from, but you can’t borrow the full amount. Your lender may limit your borrowing to 85% of your home’s equity. For example, if your home is worth $300,000 and you owe $125,000 on your mortgage, you have $175,000 in available equity. However, the maximum you’d be able to borrow is $148,750.
Credit score requirements vary by lender and might be more strict than some minimum mortgage requirements, said Michael Becker, a branch manager with Sierra Pacific Mortgage in Lutherville, Md. As with other financial products, the higher your credit score, the better your interest rate.
“Depending on the loan-to-value (ratio) that you want to go to, you’d need a different credit score,” he said, adding that many lenders require a minimum 660 to 720 credit score for home equity loans, based on the amount they’d want to borrow. Generally, the higher your LTV ratio, the better your credit score needs to be.
Your loan-to-value ratio is calculated by taking the loan amount secured by your home and dividing it by your home’s appraised value. It’s wise to aim for a maximum combined loan-to-value ratio (the balances for your first mortgage and home equity loan added together and divided by your home’s value) of 80%, though Becker said some lenders may allow a 90% to 100% CLTV.
Your lender will also need to confirm your ability to repay the home equity loan by verifying your income, employment and assets. Your debt-to-income ratio, which is the percentage of your gross monthly income used to make monthly debt payments, is also considered and generally shouldn’t exceed 43%.
Pros and cons of a home equity loan refinance
One of the main benefits of refinancing a home equity loan is the money you’ll potentially save. This could be in the form of a lower interest rate and/or a smaller monthly payment.
There’s also the flexibility you’re provided with a home equity loan. You can use the funds for virtually any purpose, such as renovating your home, covering medical expenses or consolidating high-interest debt.
Although a home equity loan has tax benefits, there’s a drawback. Taxpayers can deduct the interest paid on first mortgages, home equity loans and home equity lines of credit worth up to $750,000 (or $375,000 for married couples filing separately). The catch here is that you can only deduct the interest paid on home equity loans or HELOCs if you’re using the funds to build, buy or substantially improve your home. So if you’re using your home equity loan to pay off your non-mortgage debt or cover your student’s college tuition, you can’t deduct the interest.
Other drawbacks include the possibility of declining home values, which could put you underwater, and the risk you take on by borrowing against your home in the first place. You’re using your home as collateral, giving your lender the right to foreclose if you default on payments.
The bottom line
A home equity loan refinance could save you money and provide some relief to your budget, but it’s important to be sure it makes sense before you proceed.
Figure out if the benefits outweigh the risks and boost your chances of approval by paying down debt, building more equity and taking steps to improve your credit score.
Remember, just as you would do when refinancing your first mortgage, be sure to calculate your break-even point, or the amount of time it would take you to recoup the costs you paid for your home equity loan refinance.
Here’s what you should know about refinancing a HELOC.