How Can I Refinance a Home Equity Loan?

Since the pandemic, the average homeowner equity has been on the rise. It was around $182,000 at the start of the pandemic and rose to $274,000 in 2022. Currently, the average homeowner equity holding is around $299,000, a significant increase from 2022. 

However, most homeowners are unaware of their equity holdings and how they can profit from them. One major tool that can enable homeowners to encash their increased home equity is refinancing. Read on to learn all about home equity and refinancing.

What Is Home Equity?

Home equity represents the portion of the house’s value that the homeowner holds. It can also be understood as the mortgage-free or the lien-free portion of the home. It is calculated using the property’s current market value, which is base value plus the appraisal over the years. The mortgage amount paid over the period is also considered (deducted) when calculating home equity. 

So, the formula for calculating home equity is:

Home Equity = Current Market Value of the House – Outstanding Mortgage Balance

Refinancing Home Equity Loan

Refinancing a home equity loan means financing an already financed home. The portion of the owner’s home equity, which is mortgage-free, is financed in refinancing. Here is an example for you to better understand the concept

You bought a house for $250,000 with a mortgage of $200,000. Over time, you’ve paid your mortgage and now owe $180,000. Plus, your home has appreciated and is now worth $300,000.

Your current home equity is:

HomeEquity=Value of Property−Mortgage Balance

Home Equity = $300,000 – $180,000

Home Equity = $120,000

So, if you decide to refinance $40,000 of your home equity, your new mortgage balance will be $240,000 ($200,000 original mortgage + $40,000 borrowed for the kitchen).

Your remaining home equity after refinancing is:

HomeEquity after Refinancing=Value of Property−New Mortgage Balance

Home Equity after Refinancing = $300,000 – $240,000

Home Equity after Refinancing = $60,000

How to Refinance a Home Equity Loan?

Refinancing a home equity loan will reduce your housing finance cost. It will make your monthly installments more affordable and save you a significant amount.

However, there are several ways of refinancing a home equity loan, and there is no one-size-fits-all solution. Therefore, before deciding on what route you want to take, weigh the pros and cons of each thoroughly:

Refinance into a New Home Equity Loan

Refinance into a new home equity loan is one of the most common ways of refinancing a home equity loan. In it, you can swap out your current home equity loan for a new one. The new loan can be of equal or greater size, depending on your equity. 

However, extending the loan term could mean paying more interest, even with a lower rate. Additionally, borrowing increases the risk of losing your home if your finances deteriorate.

Refinance Into a Home Equity Line of Credit (HELOC)

A Home Equity Line of Credit (HELOC) is a very popular way of refinancing home equity as it allows you to make interest-only payments for its draw period, generally 10 years. This way, you get a very nominal monthly installment amount for a significant period. But, as the interest rate here is flexible, you risk paying high interest compared to other options.

Refinance Into a New First Mortgage

Another way of refinancing home equity is to merge home equity loans and first mortgages into a single loan. This way, you benefit from reduced interest rates, better terms and conditions, and no increased liability. However, this will not be viable if the current interest rate is lower than the proposed one.

When Do You Qualify for Refinancing Home Equity Loan?

Refinancing a home equity loan is highly dependent on market trends, which fluctuate constatntly. Therefore, the qualification requirements for refinancing are stringent:

Combined Loan-To-Value (CLTV) Ratio

The Combined Loan-To-Value (CLTV) Ratio is the ratio of the total amount borrowed against the property’s fair market value. While a few lenders may accept a 100% CLTV, the common practice is to have an 80% CLTV.

Debt-To-Income (DTI) Ratio

Lenders examine the debt-to-income (DTI) ratio before sanctioning an appraisal. It ensures that the borrower has sufficient funds to pay off the loan. Generally, the acceptable DTI ranges between 43% and 50%. However, 50% DTI is a rare offer.

Credit Score

For refinancing a home equity loan, the better the credit score, the lower the interest. If you score as high as  740–850, you will get the lowest interest rate. And as the score decreases, the interest rate will increase.

Full Home Appraisal

You will need a full home appraisal to refinance a home equity loan. The appraisal can be a drive-by or automated valuation model (AVM). A full home appraisal is time-consuming and costly. Therefore, it is better to clarify the requirements with the lenders beforehand.

What if I Don’t Qualify to Refinance My Home Equity Loan?

Not qualifying to refinance a home equity loan can cause serious financial strains. It might become difficult to make loan payments on time. This will negatively impact your credit score and overall financial standing. 

If you are stuck in such situation, contact your loan service provider and enquire about loan modification. Your service provider might modify the loan repayment terms to accommodate your needs. However, the decisions will be based on your track record and financial situation. 

Cash-Out Refinance

When done correctly, there are many benefits to refinancing a home equity loan. However, despite its lucrative payouts, it might not fit you best. An attractive alternative for such instances may be “Cash-Out Refinance.” 

Cash-out refinance also lets homeowners borrow money by mortgaging an already mortgaged property. However, unlike refinancing, the old mortgage is paid off in cash-out refinance. A new, bigger loan is sanctioned, generally with a lower interest rate.

Bottom Line

Refinancing home equity loans enables homeowners to optimize their finances. However, despite all its benefits,  refinancing a home equity loan might not be the wisest decision for your financial health. Therefore, evaluate your financial standing and needs before you make big financial commitments.

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