Home equity loans can unlock extra value in your home. And just like mortgages, there are times it can make sense to refinance them to take advantage of lower interest rates.
Because a home equity loan behaves like a mortgage, it’s also known as a second mortgage. It’s different from a home equity line of credit, or HELOC, which is another form of borrowing against the value of your home. With a home equity loan, you get a lump sum paid to you; with a HELOC, you have a line of credit, up to a predefined maximum amount. With both types of borrowing, it’s important to keep in mind that your home serves as collateral, meaning the lender can seize it if you default on repayment.
Most home equity loans have a fixed annual percentage rate; those with adjustable rates, which can fluctuate with the economy, are rare. You’ll make monthly payments over the life of the loan, paying interest and paying down the principal according to an amortization schedule. And just like with primary mortgages, home equity loan recipients can benefit from refinancing when rates are lower than their current loan.
Lenders might be persuaded to reduce or waive closing costs on a new mortgage, subject to certain conditions.
“You want to refinance your home equity loan if you want to lower your monthly payment, lock in a lower interest rate, switch from an adjustable interest rate to a fixed interest rate, shorten or extend the term of the current home equity loan, or borrow additional funds,” says Travis Tracy, a Certified Financial Planner at Fortitude Financial Planning.
Consolidating higher-interest debt like credit card debt can be another reason to consider refinancing a home equity loan. A lower interest rate could put more money in your pocket every month. The extra funds you would then have at your disposal could go to paying down that other high-interest debt. Just keep in mind the risks of trading unsecured debt for secured debt like a home equity loan.
You could also apply for a new loan in a larger amount than the first, to help cover large expenses that may have arisen since you got the original loan, such as additional home renovation projects.
Having a budget, or starting one, will help you determine what the best destination for the extra funds that a refinance will put at your disposal.
“As long as you fix your budget habits, this can be a great way of reducing interest costs and coming up with a clear path forward,” says Mark Struthers, a Certified Financial Planner at Sona Wealth Advisors.
When It Doesn’t Make Sense to Refinance a Home Equity Loan
Just because you can refinance your home equity loan doesn’t mean you should.
“You may want to hold off on refinancing your current home equity loan if your credit score dropped from when you took out the original loan, or if your debt total has increased,” says Tracy. He also suggests holding off if you’ve recently lost employment, since employment status is one of the major factors a lender will consider.
It may also be difficult to refinance a home equity loan if the value of your home has decreased, Tracy adds. The loan-to-value ratio, or LTV, is a key metric lenders consider for issuing or refinancing a home equity loan; the lower, the better, all other factors being equal.
Like with a regular mortgage, you should also consider closing costs, which amount to 2% to 5% of the loan, according to several lenders. They can be rolled into the overall loan amount, so you will not have to come up with possibly thousands of dollars at closing. A lender might also be willing to reduce or waive them, so it pays to shop around. Beware, however, that you may have to repay them if you pay off the loan before a certain period, since the lender would then lose out on your interest payments.
You can refinance with your current lender, or find a new one; the former will not necessarily offer you the lowest rate, so shopping around is recommended, Tracy says.
With either option, you will need to provide the lender detailed information about your property, your income and employment status, remaining balance and monthly payments on your first mortgage, and any other outstanding debt.
The lender will then review this information and your credit score. Typically, you’ll need a credit score of 620 or above to refinance, Tracy says. Keep in mind that scores below the threshold generally considered to be good credit, 720, will result in far higher interest rates than would be available to borrowers with better credit.
Refinancing your home equity loan can help your long-term financial strategy, but it’s important to know what it entails before you jump in. Locking in a lower interest rate and lowering your monthly payments are very attractive, but seeking a refinance may not be a good idea if your credit score dropped or your debt total increased.
If you do decide to go ahead, take your time to shop around for the best rate, and inquire about reducing or even waiving closing costs. With a little bit of legwork and due diligence, you could end up with a solid deal.