Learn How to Refinance a Home Equity Loan
Earlier this year, home equity hit 58 percent of home values, making this the highest year for home equity in the past decade. However, surprisingly, many people are avoiding refinancing their home equity loans. If you don’t know how to refinance a home equity loan, or even what it means to refinance a home equity loan, that might be holding you back.
However, refinancing a loan can be a great way to put yourself in a more stable financial position in the future.
We’ve put together this essential guide to help you understand how to refinance a home equity loan, with all the knowledge you’ll need to get started. Read on to learn more!
What Is a Home Equity Loan?
A home equity loan is when you borrow money based on the value of your home.
When you need to borrow a lot of money, such as when making an investment in your career or education, this can be a great way to do it.
Homes have a lot of value stored within them, and since you already own the home you’re borrowing against, this is often an easy type of loan to qualify for.
Home equity loans are sometimes known as “second mortgages“. The money that you borrow to buy the house in the first place is the first mortgage. However, you can then take out another loan on your house, as long as you have enough equity.
What is Equity?
Before we jump into learning about how to refinance a home equity loan it’s best to start with some basic terminology. If you are just starting down the road to buying a home, many of these terms will be new to you.
Equity is the difference between your home’s value and the amount of money you still owe on it.
Wondering how much equity you have? Just take the current market value of your home, and subtract the balance of any loans you haven’t paid yet.
Another way to look at it is that equity is the amount of money that you’ve paid toward your home so far. If you’ve owned your home and made payments on it for many years, you’ll have more equity than someone who just bought their home.
Your equity goes up as you make payments. However, it can also go up if your home increases in value.
Why Get a Home Equity Loan?
There are many benefits to taking out this type of loan.
This kind of loan tends to come with low interest rates, so the cost of borrowing is relatively low. And, since you already own the home, they’re fairly easy to get approved for – even if you have a low credit score.
Banks don’t balk at making this kind of loan, because using the home as collateral means it is a safe loan for the bank: they are guaranteed to be paid back.
That said, not all home equity loans will be approved. The 2007 housing crisis did make banks a bit more cautious about giving out these kinds of loans.
But the economy is much better now, so getting these loans is once again becoming easier. Generally speaking, you just can’t borrow over 80 percent of the home’s value.
Paying a Home Equity Loan
In order to understand how to refinance a home equity loan, you need to also understand how paying back these loans functions.
There are two ways to approach paying back a home equity loan.
1. Lump Sum
With this method, you’ll take out the loan in the form of a lump sum. Then, you’ll use fixed monthly payments to pay it back over time. You’ll use an interest rate that’s set up front, and the payments will go toward both paying the interest and paying off the loan balance.
2. Line of Credit
In this option, you’ll be approved for a maximum loan amount, kind of like a credit card. You’ll borrow what you need, as you need it. This is a good way to borrow a few smaller amounts, rather than one large amount of money.
This method also lets you start off with smaller payments as you pay off what you’ve borrowed.
What Does It Mean to Refinance a Home Equity Loan?
If you take out a home equity line of credit, or HELOC, you can start out making smaller monthly payments. However, once you reach the 10th anniversary of taking out the loan, you’ll often see a sharp increase in the amount of money you’re required to pay each month.
Refinancing your loan is one way to delay this monthly payment increase, which can help you keep your finances stable.
There are two parts to a HELOC. The first step in the loan payment process is the “draw period.”
This period is usually 10 years long, although it can be up to 20. During this period, your monthly payments may pay off only the interest on the amount of money you’ve borrowed.
Once that time is up, you hit the “amortization period.” During this time, you’re required to start paying back the principal loan amount, as well as the interest, each month.
Depending on how much you’ve borrowed, this can result in a steep increase in monthly payment amounts. If you’re not ready for that sharp increase, though, it’s okay – you can refinance.
Should You Refinance a Home Equity Loan?
It’s easy to see that there are many benefits to deciding to refinance a home equity loan. If you don’t have lots of extra cash to pay loans back with, refinancing is a great option.
If you want to pay a smaller amount monthly, you should refinance. However, refinancing is also a good way to get a lower interest rate lock. It also can let you change to a more stable fixed-rate loan from an adjustable-rate one, or to a flexible adjustable-rate loan from a fixed-rate one.
Refinancing is also a good way to open up funds for other things, such as college, home improvements, or a new business venture.
How to Refinance a Home Equity Loan
Here are some of the key elements you should be aware of on how to refinance a home equity loan.
If you’re approaching the amortization period, it’s important to stay organized and well prepared. Don’t delay to start the process of refinancing.
Typically, your bank will contact you 6 to 12 months before that period starts. They’ll remind you of the pending end of the draw period, so you can decide what to do next.
There are a few different ways you can refinance.
1. HELOC Refinance
With this method, you’ll simply start a new HELOC, with a brand new draw period.
This buys you more time before paying off the loan – you’ll have another 10 to 20 years of making interest-only payments.
2. Home Equity Loan
If you have a HELOC that’s entering the amortization period, you can actually take out a fixed home equity loan to pay it off. Home equity loans allow you to make the same monthly payments until the loan is paid off, with no sudden increases.
3. New Primary Mortgage
You can also refinance your first mortgage and your HELOC at the same time, taking out a new primary mortgage instead.
This method lets you refinance into a 15- or 20-year mortgage for lower fixed interest rates, if you choose. It’s a great option when interest rates on mortgages are already low.
What to Do Before Refinancing
Before you take the steps to refinance a home equity loan, there is some information you’ll need to gather in order to make the most informed decision. Taking these steps helps make sure you get the best loan for you.
1. Calculate Your Equity
You’ll once more need to figure out what you can borrow against on your home. As above, subtract the value of any unpaid home loans from the current market value of your home.
The home equity loan you need to refinance will be part of those unpaid home loans, so don’t forget to add that value to your calculations.
2. Figure Out How Much You Need
Are you using the refinance to pay for a new project, or just to get lower monthly payments?
If it’s the former, figure out how much money you realistically need, then compare that to the amount of equity in your home.
3. Decide on Your Payment Goals
You’ll need to be realistic about how much you need, how much you can borrow, and how much you can pay each month.
When you refinance, you reset your payment terms. Consider your financial needs, and be realistic about monthly payments that you can stick to in the long term.
Don’t forget to factor in interest rates. Usually, the longer the loan term, the higher the interest.
4. Look at Your Credit Score
If your credit score is lower than it was before, that may make it harder to refinance a home equity loan.
You’ll be taking out a new loan, so the bank will be paying attention to your credit history and how the original loan affected your score. A lower score doesn’t necessarily mean you can’t refinance, but it’s something to take into consideration.
Ready to Refinance a Home Equity Loan?
Armed with this knowledge, you’re well prepared to make the right decision about how to refinance a home equity loan.
This can be a great way to stay on track financially, and even pay for major new endeavors.
Even if you have bad credit, don’t discount this option. We can help. Check out our tips for getting home equity loans with bad credit here.
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