Refinancing Your Home Equity Loan: A How-to Guide

Much depends on whether you also want to refinance your first mortgage

You could be thinking about refinancing your existing home equity loan for several reasons. You might want to reduce your monthly payments by getting a lower interest rate or extending your loan term. Or you might instead want to shorten your loan term, so you will pay less total interest in the long run and become free of debt sooner. You might even want to take more cash out of your home's equity for a large purpose or remodel.

Whatever your reason, here are your options and the main steps you need to take in each case.

Key Takeaways

  • When refinancing a home equity loan, if you also want to refinance your first mortgage, a cash-out refinance is the way to go.
  • If you are happy with your first mortgage, then you should simply refinance your existing home equity loan.
  • In either case, having a good credit score and a low loan-to-value (LTV) ratio is crucial to getting the best refinance terms.

Option 1: Cash-out Refinance

A cash-out refi of your loan 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 value, you might even be able to pocket some additional cash.

People use the cash-out option for large purchases such as cars or remodeling services because the home equity loan's interest rates will often be lower than a personal loan or auto loan. In fact, if the loan proceeds are used to repair or upgrade your home, the interest may even be tax-deductible in some cases.

Why This Choice Might Be the Right One

Ask yourself these questions when considering if it makes sense to refinance your first mortgage:

  • Do you have a variable-rate loan that you want to turn into a fixed-rate one before interest rates go up?
  • Do you have a fixed-rate loan with a higher interest rate than you could get today?
  • Do you have a Federal Housing Administration (FHA) loan that was the only option you could qualify for at the time, but now your circumstances have improved, and you'd like to have a less expensive conventional loan with no mortgage insurance (PMI)?

Just as there are several 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 often be your main considerations.

Determining Eligibility

To be eligible for a cash-out refinance, you must have owned the home for at least six months. You will 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, cover closing costs, and still have at least a 20% remaining equity stake in your home.

Lenders commonly sell off the mortgages they originate to Fannie Mae or Freddie Mac. To do so, they must follow Fannie’s or Freddie’s lending guidelines. Fannie Mae will not buy cash-out refinance loans on a single-unit principal residence (i.e., your house) with a loan-to-value (LTV) ratio higher than 80%. If you have a high-balance loan (limits will vary by county), your LTV ratio cannot be higher than 60%. If you have listed your home for sale in the past six months, the maximum LTV ratio allowed is 70%.

You will also need a minimum credit score of around 640 to 680, depending on your LTV ratio. Understand that lenders may have their own, stricter standards and require a higher credit score.

Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).

Loan-to-Value Requirements: An Example

Here is an example of how the LTV requirements work on a typical cash-out refinance that requires an 80% LTV ratio. Say your home is worth $300,000, so you would need to have $60,000 in equity left after doing a cash-out refi. That means your first mortgage plus your home equity loan cannot total more than $240,000.

It is good to understand how this calculation works, but you can also utilize one of several free online cash-out refinance calculators to do the math for your situation quickly and without error.

To find out how much equity you have, your lender will order an appraisal, which will cost you a few hundred dollars.

Closing Costs

A 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 are refinancing to save money, you need to figure out your break-even period and see how many months you will 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 also finance your closing costs, which eases the sting of this added expense in the short run and they will instead be rolled into your monthly payments. However, if your goal is to spend less over the long run, pay them upfront. Otherwise, you will be paying interest on them until your loan is paid off.

As another possibility, if you are refinancing a relatively small mortgage balance, find a lender that offers a specialty product. U.S. Bank, for example, 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 are happy with your first mortgage, or if you have no need to take out extra cash as a loan, you would probably want to look into refinancing with a new home equity loan.

Why This Choice Might Be the Right One

You might want to get a new loan in the same amount as what you currently owe on your current loan in order to save money with a lower interest rate or a shorter term. You might be interested in a new loan for a slightly larger amount if you want to borrow to cover new expenses. 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. Still, it is a better option than defaulting on your existing loan if you’re having trouble making the payments.

Determining Eligibility

Again, you will need to meet minimum LTV 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 will also 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.

Home equity loans and cash-out refi generally have higher interest rates than simply refinancing a first mortgage, and the latter usually has higher rates than the former.

A Home Equity Loan vs. a Cash-out Refinance

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 refi's have higher interest rates than simply refinancing a first mortgage, and a cash-out refinance sometimes has a higher interest rate than a home equity loan. In either case, the rate will depend on your LTV ratio and your creditworthiness.

With either the cash-out refinance or the new home equity loan, you have 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 will 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 declarations page, if applicable; and most recent mortgage and home equity loan statements. Be prepared to provide other documents as the loan underwriter requests them, especially if you are self-employed.

The Bottom Line

Ultimately, it is 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, as lending standards vary somewhat. Shop around with banks, mortgage brokers, online lenders, and credit unions to find the best deal.

Article Sources

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  1. Internal Revenue Service. "Interest on Home Equity Loans Often Still Deductible Under New Law." Accessed Jan. 9, 2021.

  2. Fannie Mae. "Eligibility Matrix," Pages 2-4. Accessed Jan. 9, 2021.

  3. Federal Trade Commission. "Mortgage Discrimination." Accessed Jan. 9, 2021.

  4. US Bank. "Smart Refinance." Accessed Jan. 9, 2021.