A lender provides a Home Equity Line of Credit (HELOC), which has a credit limit, a variable interest rate, and is secured by a home’s equity. A HELOC is a type of “revolving” credit in which the borrower can withdraw money up to a specified credit limit. The account is refreshed each month as the borrowed money is paid off.

Credit cards are another sort of revolving credit, but often have high-interest rates, making borrowing significant amounts of money pricey.

With its low-interest rate, HELOCs are very popular with homeowners who need some extra cash for any type of purchase. Some common uses for a HELOC include home renovations, buying a second home or investment rental property, paying for college tuition, and paying-off high-interest debt.
 
A HEOC is a “secured loan,” meaning that lenders require that the borrower put up security or collateral (in this case the borrower’s home) to secure the loan. Because your home is used as collateral, if you default on the loan, the lender can take possession of your home.

Refinancing a HELOC can include the same steps you followed to secure your original HELOC. Before you shop for a new loan, ask your current lender how to refinance a home equity line of credit. If you’re a customer in good standing, you may qualify for a better interest rate and waived application/processing fees. 

Here are some typical eligibility requirements:

Home Equity: According to the Federal Trade Commission, depending on your creditworthiness and outstanding debt, you may be able to borrow up to 85 percent of the appraised value of your home, minus the amount you owe on your first mortgage.

Debt-To-Income Ratio (DTI): Your debt-to-income ratio is all your monthly debt payments divided by your gross monthly income. This number is one way lenders measure your ability to manage the monthly payments to repay the money you plan to borrow. Many lenders will require that a borrower have a DTI of less than 43 percent.

Loan-To-Value Ratio (LTV): This is another value that lenders use to calculate borrower risk. To calculate your LTV, use the following equation:
LTV = Amount owed on the loan ÷ Appraised value of your home.

To convert this to a percentage, multiply the sum by 100. Lenders generally accept an LTV up to 80 percent.

Credit History: The lender will ask to view your credit history and credit score. Lenders use credit scores to determine the risk of lending to a particular borrower. The higher your credit score, the better (lower) the interest rate you’ll be given.

Home Value: An appraisal will likely be required to determine you home’s value. Some lenders will do a “drive-by” appraisal and take exterior photos to get the information they need; other lenders may use local and county valuation data to determine a home’s value.

How to Refinance a Home Equity Loan

Refinancing a home equity loan, involves replacing your existing loan with a new one, potentially to secure a lower interest rate, adjust the repayment term, or tap additional equity from your home’s increased value.

Read Also: Leveraging HELOC Calculators for Smart Financial Planning

Let’s say you have an HE loan that you took out a few years ago at 8 percent, the then-prevailing interest rate. Since then, general interest rates have dropped, and now loans are available at 6.5 percent. Additionally, your home’s value has increased, and you’ve built up more equity. By refinancing, you could lower your monthly payments. You could also restart the clock on your repayment schedule (for a longer or shorter term), or even borrow more cash.

Steps to refinancing your home equity loan

1. Assess your position: It starts with determining whether refinancing is beneficial for you. Look at the current interest rates compared to what you have, calculate potential savings over time, and consider how long you plan to stay in the home (you want it to be long enough to “break even” – that is, have the savings outweigh the costs you’ll pay upfront to refinance).
2. Equity check: Calculate your current equity stake. If your home’s value has increased, for instance, from $250,000 to $300,000, and you have paid down your mortgage and previous home equity loan to a total outstanding amount of $200,000, you have $100,000 or a 33 percent equity stake — enough to consider refinancing.
3. Credit score review: Check your credit score because a good score can lead to better interest rate offers. For example, raising your credit score from 670 to 740 might drop your rate by a whole percentage point.
4. Shop for lenders: Reach out to several lenders to find the most favorable rates and terms. For example, one lender might offer a 4.5 percent interest rate with no closing costs, while another could offer 4.25 percent with closing costs. You’d want to choose the latter.
5. Document preparation: Gather important documents such as recent pay stubs, tax returns, and bank statements that prove your income and financial stability.
6. Understand the costs: Know the associated expenses of refinancing. These might include application fees or an early payoff penalty on your existing loan. For example, if your lender charges a 2 percent prepayment penalty on your $20,000 home equity loan, you’ll owe $400.
7. Decide on the loan type: Based on your goals, decide if another fixed-rate home equity loan, a variable home equity line of credit (HELOC), or a cash-out refinance works best for you. A HELOC might offer a good option if you prefer to access your equity on a rolling basis, rather than a lump sum. A cash-out refi would probably offer a lower interest rate, but it does involve replacing your current mortgage.
8. Loan application: Apply for a new loan. Depending on the lender’s requirements, a new property appraisal might be needed to assess your home’s current value.
9. Review offers: When you get offers, compare the details, being sure to look at the annual percentage rates — the APRs give a truer sense of the total cost of the loan since they include fees. If you’re going for a variable-rate HELOC, be sure you understand how often rates will fluctuate and by how much per year.
10. Close the loan: At closing, settle any upfront costs. Apply a new loan to pay off your existing home equity loan. Then, your new payment plan begins according to the fresh terms.

Having the old loan doesn’t automatically make you eligible for the refinance. Just like the first time around, you need to be able to qualify

For a home equity loan, the first requirement is that your home serves as adequate collateral to secure the loan. Most lenders require you to have a combined loan-to-value (CLTV) ratio of no more than 85 percent, meaning the sum of all your outstanding home-backed debts (primary mortgage, home equity loan) makes up no more than 85 percent of your home’s total value. In other words, you own at least 15 percent of your home free and clear.

While you’ll have already met this benchmark when you first got your home equity loan, you’ll have to revisit it if you want to refinance — it’s possible your home’s value dropped since you first took out the loan.

This isn’t a common situation to face, but it can happen if the residential real estate market has softened significantly. It may also happen if you’ve done a cash-out refinance of your mortgage and took a good chunk of equity out of the home.

You also need to meet personal financial and credit requirements. That means having at the very least a fair credit score — starting at 580 —though many lenders require a 620 minimum for refinances in general. Standards for home equity loans tend to be tougher, though, because these second mortgages fall behind primary mortgages in the pecking order of creditor repayment should you default. According to Experian, you’ll usually need a credit score of at least 680 to qualify for a home equity loan, and many lenders prefer a credit score in the 700s. Even among lenders who work with “bad credit” candidates, the average minimum is around 630.

You also have to have sufficient income to make payments on the loan and a low debt-to-income ratio (DTI) — that is, the monthly bills you pay should generally comprise no more than 43 percent of your monthly gross income.

Finally, you should have a good repayment record with the current home equity loan — especially if you want to refinance with the same lender. They may be hesitant if you’ve missed payments, been late or fallen short. Conversely, if your financials are a little weak but your record is solid, they may cut you some slack, given you’ve been a reliable borrower as far as their loan is concerned.

Common Reasons for Refinancing a Home Equity Loan

There are several good reasons to refinance your existing home equity loan. They include:

• Reduce your monthly payment. Often, refinancing your home equity loan will result in having to pay less each month. This happens in one of two ways: You score a better (i.e., lower) interest rate on the new loan, or the new loan has a longer term.
• Lock in a lower interest rate. Many people refinance their home equity loans because interest rates have significantly dropped. Locking in a more favorable interest rate can make a significant difference in monthly payments.
• Switch from an adjustable rate to a fixed rate. If your home equity loan currently carries a variable rate, switching to a fixed-rate loan offers more stability. You will have a predictable payment each month instead of one that fluctuates with interest rate trends. (Conversely, you may want to ditch a loan with a high fixed rate in favor of the variable rate variety, if interest rates seem to be on a long-term downward course.)
• Borrow additional home renovation funds. Homeowners taking on a major repair (damaged roof, non-functioning furnace) or remodeling often find home equity loans the most affordable way to fund these five-figure projects. If you’ve got a job that’s running above budget, or you’ve augmented it in some way, a refinance could get you help, with the same potential tax benefits and lower costs.
• Customize repayment terms. If you have a 15-year repayment term on your home equity loan with 10 years left, refinancing gives you the opportunity to change those terms. You can either shorten the term to pay it off more aggressively or lengthen it to allow yourself more time to complete the loan.

Pros and Cons of Refinancing a Home Equity Loan

Pros

The benefits to refinancing a home equity loan include:

• Lower your monthly payments: All else being equal, if you can get a lower interest rate, you’ll save on your monthly payments and interest overall.
• Shorten or stretch your repayment term: Transitioning to a longer term, such as 10 years instead of five, will decrease your monthly payment but also add to your interest charges. Alternatively, you might opt for a shorter loan term, which raises your monthly payments but allows you to pay off the debt faster, saving you on interest and freeing up room in your monthly budget sooner.

Cons

The drawbacks to refinancing a home equity loan include:

• Prepayment penalty: Depending on the type of home equity loan and your lender’s policy, you might be subject to a fee if you pay it off early (which is essentially what refinancing does) or before a certain time frame.
• Repayment risks: If you can’t keep up with the payments on the new loan (say you converted to a shorter-term loan with a higher monthly payment), you open yourself up to the possibility of foreclosure.
• At the mercy of the market: If your home declines in value, you could wind up being underwater — that is, owing more between your mortgage and home equity loan than the home is worth. If the real estate market has already softened, you might not be able to refinance at all.
• Increase the interest: Refinancing your home equity loan will reset the repayment term; unless you specifically chose a shorter loan, this means it will extend the debt. That can lower your monthly payment but means you’ll pay more money in interest, for longer. If you go to sell the home, that could mean a bigger bite into your proceeds, as you’ll have to pay off the home equity loan immediately.

You can definitely refinance a home equity loan into a home equity line of credit (HELOC), but it’s vital to weigh the potential benefits against the drawbacks.

Benefits of refinancing into a HELOC

• Potential for lower interest rates: If market interest rates have fallen since taking out your original loan, switching to a HELOC could help you secure a lower rate, reducing overall interest costs. And you’d benefit from additional declines throughout the HELOC’s term, as your rate would adjust with the market.
• Flexibility: Unlike the lump-sum payout of a home equity loan, a HELOC provides you with a revolving line of credit. This allows you to tap into funds as and when you need them, offering enhanced financial flexibility.

It is also possible to refinance both a home equity loan and your primary mortgage simultaneously. This is typically achieved through a cash-out refinance, which entails taking out a larger mortgage than your current one and getting the difference in ready money. In this case,  you can use the surplus funds to pay off your home equity loan

Advantages of refinancing both loans simultaneously

• Debt consolidation: This option allows you to combine your primary mortgage and home equity loan into a single payment, simplifying your financial management and potentially offering a lower overall interest rate than a standard home equity loans (refis tend to run a percentage point or two cheaper).
• Access to cash: The “cash-out” part of a cash-out refinance means you end up with additional funds. If there’s anything left after paying off the home equity loan, you could use the cash for various expenses like home improvements, credit card bills or tuition.

Disadvantages to refinancing both loans simultaneously

• Potential for higher interest rate: Cash-out refinances often attract higher interest rates than standard rate-and-term refinances, which could lead to increased costs over the life of the loan. Also, the prevailing interest rate may be higher than that on your current mortgage.
• Increased loan amount and duration: You’ll essentially be taking out a larger loan, and extending your repayment period. This might lead to higher total interest payments, especially if you don’t plan on accelerating your payments to compensate for the reset amortization schedule.

A mortgage refinance is essentially getting a new mortgage — with all the costs and time-consuming procedures that implies. You might not want to let yourself in for the extra complications if all you really need is to update your HELoan. It’s also not advisable if it means giving up a low-interest rate on your present mortgage.

Final Thoughts

As with a typical mortgage refinance, you must apply for a home equity loan refinance with either your current lender or another. Prepare to supply the lender with credit and financial information, as well as a list of assets and obligations.

In many ways, it’s the same as the first time around — but refinancing is often easier because you’ll be applying for a smaller quantity and will most likely have an excellent track record of repaying the original debt. Still, you want your financial picture to appear as solid as possible.

In general, the best reason to refinance a home equity loan is if interest rates have dropped since you took it out. Just be sure to consider your timeline for staying in the home, be aware of any change in your home value, and take into account any fees you might incur (yes, a refinance incurs closing costs, just like the original loan did).