You can refinance a home equity loan just as you would a regular mortgage. But there are some special considerations to think about before you proceed. This article explains when you might want to consider refinancing a home equity loan and how to go about it.
Key Takeaways
- You might want to refinance your home equity loan if you can get a substantially better interest rate on a new one.
- Before you refinance, check to see if your loan imposes a prepayment penalty for ending it ahead of schedule.
- One alternative to refinancing a home equity loan is to refinance your main mortgage with a cash-out refinance.
How Refinancing Works
When you refinance a home loan—whether it’s your principal mortgage or a home equity loan—you take out a new loan for at least enough money to pay off the old one. After that, you make payments on the new loan. At some point in the future, you might even refinance the new loan by taking out still another one.
Why would you want to refinance a loan? A common reason is if you can get a lower interest rate and reduce your payments. Another is to obtain a loan with different terms—for example, switching from a 30-year mortgage to a 15-year one, or vice versa.
Refinancing is rarely free, however. You are likely to face closing costs and other fees, just as you did with the earlier loan. For that reason, it’s important to consider how much you’ll save by refinancing vs. how much you'll have to pay up front to do so. For example, if you can save $200 a month by refinancing, but your closing costs add up to $5,000, it will take you 25 months to break even.
Refinancing also requires some work on your part, such as rounding up all the documentation that a lender may ask you to supply. If you value your time, you might want to think about that, too.
Refinancing a Home Equity Loan
As with a regular mortgage, there are several reasons why you might consider refinancing an existing home equity loan. One is if interest rates have fallen substantially since you took out your loan. Another is if you would prefer a different term, or repayment period. For example, you might have a home equity loan that has to be paid off in five years but you would rather stretch your payments over 10 or 15 years. Still another is if you need to borrow additional money but don’t want to be paying on two home equity loans at the same time.
You can refinance your home equity loan at the bank, credit union, or other financial institution that issued your current one or with another lender. You might want to start with your current lender, which has an incentive to keep your business after you’ve paid off the old loan and may be more open to negotiating with you.
Before you commit yourself to refinancing, check to see whether your current home equity loan imposes a penalty for paying it back early. If it does have a prepayment penalty, you’ll need to assess whether it would make more sense simply to ride out the old loan until the end of its term, even if its interest rate is higher than you could get on a new one.
Under current tax laws, the interest on a home equity loan is deductible only if it’s used “to buy, build, or substantially improve the taxpayer’s home that secures the loan,” the Internal Revenue Service says.
What to Expect When You Refinance a Home Equity Loan
As with your current home equity loan, you’ll need to prove to the lender that you have enough equity in your home and that you’re a good risk. If neither of those has changed for the worse since you got your original loan, you should be OK, but you still may have to provide a lot of documentation.
Lenders typically use what’s known as a combined loan-to-value (CLTV) ratio to determine whether to offer you a home equity loan and, if so, for how much. The CLTV ratio takes into account all of the outstanding debt that you have on the property, including the first mortgage, as well as what the property is currently worth. For example, a lender might balk at issuing a new loan if those debts in total would exceed 80% of your home’s value. To verify your home’s value, the lender will usually bring in a professional appraiser.
In addition to your home, the lender will want information about you. To assure itself that you’ll have the means to repay the loan, the lender is likely to request an assortment of documents, including your pay stubs, W-2 forms, recent tax returns, bank statements, and 1099-DIVs reporting your investment income.
To check on your creditworthiness, the lender will most likely pull your credit reports from one or more of the three major national credit bureaus, as well as look up your credit score. Typically, you’ll need a FICO score of at least 680 to qualify, according to Experian, one of the bureaus.
In fact, before you even apply, you might want to check your credit reports for accuracy. You can obtain free copies more or less instantly from each of the three major credit bureaus on AnnualCreditReport.com, the official website for that purpose. If you find any inaccurate negative information, you can challenge it with the credit bureau. Your credit score is not included on your credit reports, but there are also ways to obtain your credit score free of charge.
One Alternative to Consider: Cash-Out Refinancing
Depending on your goals in refinancing your current home equity loan, you might consider a cash-out refinance instead. In a cash-out refinance, you take out a new mortgage that’s large enough to pay off your old mortgage and provide you with a lump sum in cash. You could use some of that cash to pay off your existing home equity loan and the rest for other purposes. This way, you would have just one loan to repay, and rather than needing to pay some of it back over five, 10, or 15 years, you might have 30 years.
However, be sure to compare the interest rates on the old and new loans—including both your original mortgage and the home equity loan—as well as any closing costs involved. In a time of rising interest rates (such as mid-2022), you could end up with not only more debt but also a higher interest rate on all of your debt.
What are the closing costs on a home equity loan?
Many lenders estimate closing costs at 2% to 5% of the loan amount. Some lenders advertise no closing costs, but they may be making up the difference with a higher interest rate. One way to compare costs from lender to lender is by checking the annual percentage rate (APR) that each charges. The APR incorporates some, though not necessarily all, of the closing costs into the rate that you’ll actually pay.
Can you have more than one home equity loan?
In general, yes, if you have enough equity in the home and satisfy the lender’s other requirements. However, the state where you live in also may have a say in the matter. For example, Texas prohibits residents from having more than one home equity loan on the same property at the same time.
Can you refinance a home equity line of credit?
Yes, as with a home equity loan, you can refinance a home equity line of credit (HELOC).
The Bottom Line
You can refinance an existing home equity loan with a new one, and it may be advantageous to do so if you can get a substantially lower interest rate. But check whether your current loan has a prepayment penalty, which could negate any benefit that you would get by switching.
