When you take out a home equity line of credit (HELOC), you first have a draw period, which typically lasts 10 years. During this time you can borrow money as needed and make low, interest-only payments on what you’ve borrowed. Many homeowners do just that.
After the draw period ends, however, you can no longer borrow from your line and you have to begin making fully amortized interest and principal payments. This second stage is known as the repayment period, which usually is 20 years. That means your monthly payments can be significantly higher than they were during the draw period, and many homeowners end up facing payment shock.
One way to solve the payment-shock problem is by refinancing your HELOC, and there are several ways to do it. This article explains how to qualify, what your options are, and the pros and cons of each one.
Qualifying to Refinance Your HELOC
Refinancing a HELOC is similar to taking out or refinancing a first mortgage. You’ll have to qualify based on your income, expenses, debts, and assets, which means providing documents like pay stubs, W-2 forms, tax returns, mortgage statements, photo ID, proof of insurance and any other documents the underwriter deems necessary.
To get the lowest interest rates, you’ll need to have a "very good" to "exceptional" FICO score: somewhere in the 740 to 850 range. You could qualify with a score as low as 620, but you’ll pay more than twice the interest rate of someone with an excellent score, and you may have a harder time finding a lender who will work with you.
You’ll also need to have enough equity in your home after taking out the new loan to meet the lender's guidelines for combined loan-to-value ratio – a percentage that’s calculated by dividing the total borrowed by the property value. Some lenders will let homeowners with excellent credit borrow up to 100% of the value of their home, but it’s common to be able to borrow only 80% to 90%. Here’s an example of how this is determined:
- Property value: $300,000
- First-mortgage balance: $190,000
- HELOC balance: $50,000
- Total borrowed: $240,000
- Combined loan to value: 80%
- Homeowner’s equity: 20%
In this case, assuming you only want to refinance your existing HELOC balance and don’t want to borrow more, you should be able to find a lender who will work with you, especially if you have good credit. Also, the more equity you have, the lower your interest rate will be.
Options for Refinancing Your HELOC
There are four ways to refinance your home equity line of credit. Here are your options, and the pros and cons of each:
1. Request a Loan Modification
How it works: Contact your lender and explain that you’re going to have trouble making your payments when the draw period ends. Ask if the lender can work with you to change the loan terms in a way that will make your monthly payments affordable, so you don’t default. Bank of America, for example, has a home equity assistance program that grants qualified homeowners a longer term, lower interest rate or both if they’ve experienced a financial hardship such as loss of income or divorce.
Pros: Loan modification may be your only option if you’re underwater.
Cons: Lenders are under no obligation to modify your loan, so this option might not be available to you. If it is, you’ll have to show that you can repay the modified loan. Two assistance programs for struggling homeowners, the Home Affordable Second Lien Modification program and the FHA Short Refinance, both stopped taking new applicants at the end of 2016.
2. Open a new HELOC
How it works: You kick the can down the road by starting over with a new draw period and the new interest-only repayment period.
Pros: It buys you some time to improve your financial situation if you’re struggling to make ends meet and you don’t want to default on your existing loan.
Cons: You’re going to have to repay your loan someday. The longer you put off repaying it, the more interest you’re going to owe, and the higher your fully amortized principal and interest payments will be each month. Also, entering a new draw period makes it easy to keep borrowing. If you’re refinancing because you’re concerned about repaying your existing HELOC, the last thing you want to do is add to your debt.
As you’ve already seen, it’s hard to know what your total borrowing costs or your monthly payments will be with a HELOC because you’re borrowing a little bit here and there and the interest rate can fluctuate. Further, when your new HELOC’s repayment period kicks in, interest rates could be higher than they are today, making those monthly payments even larger.
(For more, see What to Do If You Can't Pay Back a Home Equity Loan.)
3. Get a New Home Equity Loan
How it works: You turn your variable-rate HELOC balance into a fixed-rate home equity loan. You can take as long as 20 or 30 years to pay off your balance.
Pros: You end the cycle of continuous borrowing by taking out a lump sum to pay off your HELOC, and you get a fixed interest rate with stable monthly payments. Make sure you know your long-term borrowing costs and factor them into your household’s long-term financial plan.
Cons: Some lenders have stopped offering home-equity loans, so shopping around will take more effort than it did to find the HELOC. Nevertheless, they are available, especially if you’re willing to look beyond the biggest banks – which you should do anyway because large financial institutions don’t necessarily have the best rates or the most competent customer service. Also, keep in mind that the longer your loan term, the lower your monthly payments will be, but the more interest you’ll pay.
4. Refinance Into a New First Mortgage
How it works: Instead of just refinancing your HELOC, you refinance both your HELOC and your first mortgage into one loan: a new first mortgage.
Pros: You can get the lowest interest rates available. First-mortgage rates tend to be lower than home equity loan rates because if you default on your house payments, your first-mortgage lender had dibs on the proceeds from selling your foreclosed home. In a market where the rates for HELOCs and home equity loans are 5.90% and 5.57%, respectively, the rates for 30-year and 15-year fixed first mortgages might be 4.73% and 4.16%, respectively. Assuming you refinance with a fixed-rate first mortgage, you’ll also gain the stability of equal monthly payments and knowing your total borrowing costs up front, just like you would with the home equity loan option discussed above.
Cons: Taking out the first mortgage may mean paying significantly higher closing costs than you would by refinancing into a new HELOC or home equity loan.
The Bottom Line
You may be able to get more affordable monthly payments on your HELOC through a loan modification, refinancing into a new HELOC, refinancing into a home equity loan or refinancing with a new first mortgage. Explore your options with several lenders to see which possibility offers the best combination of short-term affordability and the lowest possible long-term expenses and closing costs.
(For related reading, see How a HELOC Fixed-Rate Option Works, Home-Equity Loans and HELOCs, The Smartest Way to Tap Your Home Equity, Refinancing Your Home Equity Loan: A How-to Guide, 5 Reasons Not to Use Your Home Equity Line of Credit, Refinancing vs. Home Equity Loan, Choosing a Home Equity Loan or Line of Credit, Is Your Home Equity Line of Credit (HELOC) Tax Deductible?, Bad Credit? You Can Still Get a Home-Equity Loan, Mortgage vs. Home Equity Loan: How They Differ, What to Do If You Can't Pay Back a Home Equity Loan)