If you have a home equity line of credit – better known as a HELOC – you may have already discovered one of the dirty little secrets of that loan arrangement.
HELOCs are often easier to get into than they are to get out of.
That’s because HELOCs are a loan arrangement where all the good news takes place in the first few years, then reality hits once the honeymoon – a.k.a., the “draw period” – is over.
To get out of a HELOC, you may need to do some sort of HELOC refinance.
Fortunately, a HELOC refinance is not only possible, but there are several options if you want to do one.
Why Would You Want to Do a HELOC Refinance?
The main reason to do a HELOC refinance is because of the repayment period. The main benefits of a HELOC take place during the draw period. That’s when you can access your credit line, and make minimal payments, which are usually interest-only. This is the honeymoon phase of a HELOC I spoke of at the beginning of this article, and it’s the time of greatest flexibility.
But once the draw period ends, a HELOC turns into more serious business. At that point, not only will you continue paying interest on the HELOC, but also principal. And that principal will need to be repaid within the space of the remaining term of the loan.
For example, let’s say at the end of the draw period you owe $50,000 on your HELOC, with an interest rate of 6%. Since you’re paying interest only, the monthly payment is just $250. But when the repayment period takes effect, you’ll now be paying 6% interest plus principal.
On a 15-year HELOC with a five-year draw period and a ten-year repayment period, the monthly payment will rise to $555. That’s more than double the interest-only payment during the draw period, and higher by more than $300 per month.
Suddenly your easy HELOC payments aren’t so easy. That’s when thoughts of a HELOC refinance begin to enter the equation.
How to Refinance a HELOC
Can you refinance a HELOC? Absolutely. Just like any other type of loan, a HELOC can be refinanced. In fact, there are at least three primary ways to do it.
1. Refinance a HELOC with Another HELOC
The advantage of refinancing a HELOC with another HELOC is that it will offer you an opportunity to get the benefit of a new draw period term on the new HELOC.
The main reason you’ll want to refinance a HELOC is because of the much higher payment during the repayment period. By taking a new HELOC, you’ll get the benefit of interest-only payments for the duration of the draw period. Taking the example from above, you’ll drop your $555 monthly payment on your old HELOC back down to $250 per month interest-only, assuming you’re able to get a rate of 6%.
And naturally, if you’re able to get an even lower rate, a HELOC refinance will work even better.
But still another advantage is that if you secure a new HELOC with a different mortgage lender, your current lender may agree to recast your existing HELOC into a new one in order to keep your business. It’s not guaranteed, but it’s a definite possibility.
The disadvantage of doing a HELOC-to-HELOC refinance is that you will need to requalify for the new credit line. If nothing has changed since you took the original HELOC, you won’t have a problem. But if either the interest rate situation has deteriorated or your personal financial situation has taken a bad turn since he took the original HELOC, you could run into complications.
The latter situation can happen if the value of your property falls, and you don’t have sufficient equity to fully refinance the original HELOC. Or it can be the result of either a decline in income or a drop in your credit score, which makes it difficult or even impossible for you to qualify for a new HELOC.
But assuming you can do the refinance, the new HELOC will essentially reset the HELOC clock back to Day One, when the HELOC was your friend.
HELOC Refinance Requirements
As I just wrote, a HELOC-to-HELOC refinance will require you to make an application. You’ll need to fully qualify for the new HELOC.
To do so, you’ll need to meet the following qualifications:
- Your home equity must be equal to or greater than when you took the original HELOC. The new lender will use similar criteria in determining the size of your credit line. If your home is worth at least what it was when you took the original HELOC, you should be good to go. But if it has declined in value, you may not get the full credit line needed.
- Your credit score. HELOC approvals, as well as interest rates, are largely determined by your credit score. The better your score, the more likely you are to get the maximum credit line, and at the best possible pricing. If your score is equal to or better than it was when you got your original HELOC, you should be good in this category as well.
- Debt-to-income (DTI) ratio. Every lender establishes DTI limits. That’s your house payment – including the new HELOC payment – plus recurring non-housing debt payments, divided by your stable monthly income. Depending on the lender, your DTI should not exceed somewhere between 40% and 50% of your income.
- Relationship with the new HELOC lender. The new lender may require you to have open accounts in place. This can be a checking account, savings account, money market, certificates of deposit, or other loan accounts. If you don’t have them before applying for the HELOC, they may be required as a condition of your approval. For example, a credit union will typically require that you at least open a checking account.
2. Refinance a HELOC into a Home Equity Loan
If the primary reason for wanting to refinance your HELOC is to get out of the variable interest rate feature, that can be accomplished by refinancing the credit line into a home equity loan.
A home equity loan is basically a second mortgage. And since it’s a loan and not a credit line, it works just like a first mortgage.
You’ll take out a loan for a certain amount, which will be at least enough to repay the balance on your current HELOC. The loan will then have a fixed term, which can run between five years and 20 years. You’ll also have a fixed interest rate, which will likely be higher than the best rates available on first mortgages, but comparable to the rate on your HELOC.
You’ll have to qualify for the home equity loan, which will be very similar to the requirements for refinancing into a new HELOC.
But rather than shopping for a new refinance mortgage lender to provide a home equity loan refinance, you should first approach the bank holding your current HELOC. They may be willing to convert your HELOC into a home equity loan.
The primary advantage of a home equity loan, apart from a fixed interest rate, is that you may be able to get a longer-term than the repayment period on your HELOC. That will lower the monthly payment, often substantially.
For example, if the monthly payment during the 10-year repayment period on your HELOC is $555 at 6% interest, a 20-year home equity loan, also at 6%, will drop the payment down to $358. The lower payment will be the result of the extended term of the home equity loan compared with the repayment period on your HELOC.
3. Can You Refinance a Home Equity Loan into a Mortgage?
In a word, yes! In fact, refinances that consolidate existing first mortgages and HELOCs are one of the most common reasons people refinance their first mortgages at all.
Doing a refinance of your first mortgage will, of course, eliminate the variable-rate feature on your HELOC once and for all. Just as important, it’s very likely the interest rate on your first mortgage refinance will be lower than the rate you’re currently paying on your HELOC.
But perhaps the most important benefit is the reduced monthly payment.
Once again, let’s work an example.
Let’s say your home is worth $300,000. You have $190,000 remaining on your first mortgage, which had an original balance of $200,000, an interest rate of 4%, and an original term of 30 years. The monthly payment on that loan is $955, not including property taxes and insurance.
But you also have a $50,000 HELOC that’s entered the repayment period, with an interest rate of 6% over 10 years, and a monthly payment of $555. The combined first mortgage and HELOC payments are $1,510 per month.
If you do a refinance of both your existing first mortgage and your HELOC you may be able to lower that monthly payment.
The combination of the two loan balances is $240,000. That conveniently keeps you at 80% of the value of your $300,000 home. But if you do a no-closing cost refinance of $240,000 at 4% over 30 years, your new monthly payment will be $1,146.
Based on the monthly payment, refinancing your existing first mortgage and your HELOC balance into a new first mortgage will save you $346 per month. At least from a standpoint of monthly cash flow, that will be the best way to refinance your HELOC.
If you can find a lender that will provide lower mortgage rates, the mortgage refinance will work even better.
Alternative Ways to Refinance a HELOC
If you don’t like any of the options above, or if they are not available due to a lack of sufficient equity or some other limitation, you’ll still have a few other options.
One option is by using personal loans. These are unsecured loans that are based on your credit history and income. If you qualify, you can take a personal loan for up to $40,000 or more. What’s more, the loans are fixed-rate, and typically repayable over three or five years.
If you have excellent credit, interest rates on personal loans may be comparable to HELOC rates. But if you don’t, the rates can be considerably higher. Still, personal loans offer an option to pay off a HELOC using unsecured funds, but without having to resort to high-interest credit cards.
Balance Transfer Credit Card
If you have a relatively small amount outstanding on your HELOC, you can consider using a balance transfer credit card. These are credit cards that come with a 0% introductory APR that will usually run between 12 and 18 months.
There are some limitations to this strategy. The first is a limited credit line. It’s rare you’ll be granted a credit line of much more than $10,000. That’s why balance transfer credit cards will only work on small HELOC amounts.
Second, you’ll need a solid strategy to repay the credit line within the 0% introductory period. If you can’t, the interest rate can rise to credit card levels, which will be much higher than what you’re paying on your HELOC.
Finally, balance transfer credit cards charge a balance transfer fee, typically equal to 3% of the amount transferred. That will be $300 on a $10,000 balance transfer.
One other way to refinance a HELOC is using a 401(k) loan. Under IRS rules, you can borrow up to 50% of the best in value of your retirement plan, up to a maximum of $50,000. You’ll pay interest on the loan, but it will be paid into your own account.
And while the loan will typically need to be repaid within five years, it’ll be paid out of payroll deductions, usually as a reduction in your regular 401(k) contributions.
Should You Refinance Your HELOC?
Hopefully, in reading this article, you’ve developed a keen sense that every good HELOC needs an equally good exit strategy. In most cases, that will be a HELOC refinance.
Whether you’re contemplating taking a HELOC for the first time, or you already have one in place that’s still in the draw period, you should be working on ways to accomplish a HELOC refinance. Unless you have the funds available in your bank account to pay off your HELOC once the draw period ends, a HELOC refinance will be your best option.
There’s no time like the present to begin investigating HELOC refinance options. Now is an especially good time, because interest rates are at record low levels. If you can refinance your HELOC, either with a new HELOC, a home equity loan, or a new first mortgage, you may get a lower rate to go along with a loan consolidation. That’s a win-win, but you’ll need to act fast.