Refinancing Your Home-Equity Loan: A How-To Guide
You could be thinking about refinancing your home-equity loan for several reasons. You might want to lower your monthly payment by getting a lower interest rate or extending your loan term. You might want to shorten your loan term so you'll pay less interest in the long run and be debt free sooner. You might even want to take more cash out of your home. Whatever your reason, here's are your options and the steps you need to take in each case.Option 1: Do a Cash-Out Refinance.
A cash-out refinance of your home can be a good way to refinance a home-equity loan if you also want to refinance your first mortgage. When your new loan closes, part of the proceeds will go toward paying off your first mortgage and the cash-out part will pay off your old home-equity loan. If you have enough equity, you might even be able to pocket some additional cash. (Learn more in How to Use Your Home Equity for Cash and How To Combine Two Mortgages Into One?)
Ask yourself these questions when considering if it makes sense to refinance your first mortgage: Do you have an variable-rate loan that you want to turn into a fixed-rate loan before interest rates go up? Do you have a fixed-rate loan with a higher interest rate than you could get today? (Read Should You Refinance Your Mortgage When Interest Rates Drop?) Do you have an FHA loan (see Understanding FHA Loans) that was the only thing you could qualify for at the time, but now your circumstances have improved and you'd like have a less expensive conventional loan with no mortgage insurance? Just as there are many reasons you might want to refinance a home-equity loan, there are many reasons you might want to refinance your first mortgage. Saving money or getting out of an unsustainable loan into one you can better manage should be your main considerations.
To be eligible for a cash-out refinance, you must have owned the home for at least six months. You'll need to have enough home equity to pay off the principal balance on your first mortgage, pay off what you owe on your home-equity loan and still have a 20% stake in your home. Lenders commonly sell the mortgages they originate to Fannie Mae or Freddie Mac. To do so, they must follow Fannie or Freddie's lending guidelines. Fannie won't buy cash-out refinance loans on a one-unit principal residence (i.e., your house) with a loan-to-value ratio higher than 80%. If you have a high-balance loan (limits vary by county), your LTV ratio can't be higher than 60%. If you've listed your home for sale in the last six months, the maximum loan-to-value ratio allowed is 70%. You'll also need a minimum credit score of 640 to 680, depending on your loan-to-value ratio. Understand that lenders may have their own, stricter standards (see How Lender Overlays Prevent Mortgages) and require a higher score. For further reading, see Why does the loan-to-value ratio matter?
Here's an example of how the loan-to-value requirements work on a typical cash-out refinance that requires 80% LTV. If your home is worth $300,000, you'll need to have $60,000 in equity left after doing a cash-out refi. That means your first mortgage plus your home-equity loan can't total more than $240,000. It's good to understand how the calculation works (see How do I calculate how much home equity I have?), but you can use an online cash-out refinance calculator to quickly do the math for your situation. To find out how much equity you have, your lender will order an appraisal, which will cost you a few hundred dollars. (Learn more in The Home Appraisal: Your Key to a Successful Refinance.)
The disadvantage of choosing the cash-out refi option is that the closing costs associated with a first mortgage are usually much higher than those associated with a home-equity loan. If you're refinancing to save money, you'll need to calculate your break-even period and see how many months you'll need to have the new loan for before you come out ahead after closing costs. The shorter the break-even period, the better. Your lender may let you finance your closing costs, which eases the sting of this added expense in the short run. But if your goal is to spend less over the long run, pay them up front. Otherwise, you'll be paying interest on them until your loan is paid off. Another possibility, if you're refinancing a relatively small mortgage balance, is to find a lender that offers a specialty product. For example, U.S. Bank offers a Smart Refinance for balances of less than $150,000 with no closing costs.Option 2. Refinance into a New Home-Equity Loan
If you're happy with your first mortgage, you'll want to look into refinancing with a new home-equity loan. You might want to get a new loan in the same amount as what you owe on your current loan to save money with a lower interest rate and/or shorter term. You might be interested in a new loan for a larger amount if you have new expenses you want to borrow for. Or you might want to get a new loan with a longer term to make your monthly payments more affordable, keeping in mind that you'll pay more interest in the long run this way. But it's a better option than defaulting on your existing loan if you're having trouble making the payments. (Read Home-Equity Loans: What You Need To Know.)
Again, you'll need to meet minimum loan-to-value requirements to qualify, but these requirements are lower for home-equity loans than for a cash-out refinance. Requirements vary by lender, but if you belong to a credit union, for instance, you may be able to borrow up to 90% or even 100% of your home's value, especially if you have excellent credit and lending conditions are favorable. You'll need a credit score of at least 620 for a home-equity loan, though your interest rate will be quite high with a score that low. The best rates go to borrowers with scores of 740 or higher. Lenders often pay most or all closing costs on a home-equity loan unless you close the loan early, within the first 24 to 36 months, in which case you'll have to reimburse the lender several hundred to a few thousand dollars for the closing costs, depending on your location and loan size.
You'll need to get quotes from several lenders to see how the interest rate on a new home-equity loan compares with doing a cash-out refi, assuming you are interested in and qualify for both options. In general, home-equity loans and cash-out refis have higher interest rates than simply refinancing a first mortgage. A cash-out refinance sometimes has a higher interest rate than a home-equity loan, too. In either case, the rate will depend on your loan to value ratio and your creditworthiness. (See Understanding Home-Equity Loan Rates.)
With either the cash-out refinance or the new home-equity loan, you'll need to meet all the usual mortgage qualification standards, such as having sufficient income and low enough debt to make the proposed monthly payments, a steady employment history and a good credit score. You'll also need to submit documentation to qualify financially. Gather your two most recent bank statements, pay stubs, W-2s and federal tax returns; homeowners insurance declarations page; lender-required flood insurance (see Understanding Lender-Required Flood Insurance); declarations page, if applicable; and your most recent mortgage and home-equity loan statements. Be prepared to provide other documents as the loan underwriter requests them, especially if you're self-employed. (Read Self-Employed? 5 Steps To Scoring A Mortgage.)The Bottom Line
Ultimately, it's up to the lender to determine whether you qualify for a cash-out refinance or a new home-equity loan. You might qualify with some lenders and not others since lending standards vary somewhat. Shop around with banks, mortgage brokers, online lenders and credit unions to find the best deal. And if you're going to refinance, make sure to use the proceeds wisely (see 6 Tips To Get Approved For A Mortgage).