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When you take out a home equity line of credit (HELOC), it typically has an initial draw period lasting 10 years. During this time, you can borrow money from the credit line as needed and make interest-only payments on what you’ve borrowed. Many homeowners do just that.
However, after the draw period ends, you can no longer borrow from your credit line. Instead, you must begin making fully amortized interest and principal payments each month. This second stage, known as the repayment period, is usually 10, 15, or 20 years. Your monthly payments can be significantly higher than they were during the draw period, and many homeowners end up facing payment shock, especially if interest rates have increased.
One way to solve the payment shock problem is by refinancing your HELOC, and there are several ways to do so. For instance, you could modify the loan terms, refinance a new HELOC, or use a home equity loan to pay off the HELOC.
Key Takeaways
- Many homeowners experience payment shock when they have to start repaying the principal on their home equity line of credit (HELOC).
- To qualify for a HELOC refinance, you need to have adequate home equity to meet the lender’s guidelines.
- You can refinance a HELOC by refinancing into a new HELOC, using a home equity loan to pay off your HELOC, or refinancing into a new first mortgage.
- If you don’t qualify to refinance, loan modification may be an option.
How to Qualify to Refinance Your HELOC
Refinancing a HELOC is similar to refinancing a first mortgage. You will have to qualify based on your income, expenses, debts, and home value. This means providing documents such as pay stubs, W-2 forms, bank statements, and tax returns and paying for a full home appraisal, a drive-by appraisal, or an automated valuation model (AVM) appraisal.
To get the lowest interest rates, you’ll need to have a “very good” to “exceptional” FICO score: somewhere in the 740–850 range. You could qualify with a score as low as 620, but you will often pay more than twice the interest rate of someone with an excellent score, may not be able to borrow as much, and may have a harder time finding a lender who will work with you.
Lenders will also want to see that your existing monthly debt payments plus the monthly payment on the loan for which you’re applying won’t total more than 45% of your income. They call this calculation your debt-to-income (DTI) ratio.
Finally, you’ll need to have enough home equity after taking out the new loan to meet the lender’s guidelines for your combined loan-to-value (CLTV) ratio—a percentage that’s calculated by dividing the total amount you’ve borrowed against your home by the property’s fair market 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 85%.
An Example of a HELOC Refinance
Let’s say that your home is worth $300,000. You have a first mortgage balance of $190,000 and a HELOC balance of $50,000. This means a total of $240,000 has already been borrowed against your home. If you divide $240,000 by $300,000, you get a CLTV ratio of 80%. This means that your home equity is 20%.
In this case, assuming that you only want to refinance the existing HELOC balance and do not 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 home equity you have, the lower your interest rate will tend to be. With some lenders, you may need a CLTV ratio no higher than 60% or 70% to get the lowest interest rate.
Per the Fair Housing Act, mortgage lending discrimination is illegal. If you think that you’ve been discriminated against based on “race, color, religion, sex (including gender, gender identity, sexual orientation, and sexual harassment), familial status, national origin, or disability,” there are steps that you can take. One such step is to file a report with the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD).
Ways To Refinance Your HELOC
There are three ways to refinance your HELOC and one fallback option. Here are your choices and the pros and cons of each.
1. Open a New HELOC
How It Works
You can kick the can down the road by starting over with a new 10-year draw period and a new interest-only repayment period.
Pros
You won’t have to repay your loan principal for another 10 years. Refinancing your HELOC buys you some time to improve your financial situation if you’re struggling to make ends meet and don’t want to default on your loan.
Cons
You’ll have to repay the loan someday. The longer you put it off, the more interest you’ll pay over time. It’s hard to know what your monthly payments or total borrowing costs will be with a variable interest rate, which HELOCs generally have.
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, adding to your debt will only make your financial situation more tenuous.
2. Refinance Into a Home Equity Loan
How It Works
You can use a home equity loan to pay off your HELOC.
Pros
With a home equity loan, you may get up to 30 years to repay your balance instead of the 20 years that you likely had with your HELOC. Your new loan will have a fixed interest rate, and every monthly payment will be the same. The longer term could make your monthly payments more affordable, and the predictability of those payments could make them more manageable.
Cons
By lengthening your loan term, you may pay more interest in the long run. Also, since home equity loan rates are fixed, your rate won’t increase if market rates go up, but it also won’t decrease if they go down.
3. Refinance Into a New First Mortgage
How It Works
Instead of just refinancing your HELOC and continuing to have two mortgages, you can refinance both your HELOC and your first mortgage into a single loan.
Pros
You can get the lowest fixed interest rates available. First mortgage rates tend to be lower than home equity loan rates because if you default on your payments, then your first mortgage lender has dibs on the proceeds from selling your foreclosed home.
Assuming that 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 as you would with the home equity loan option discussed above.
Cons
Taking out a new first mortgage may mean paying significantly higher closing costs than you would pay when refinancing into a new HELOC or home equity loan. Closing costs to refinance can total 2% to 5% of the loan amount, while many lenders will actually pay your closing costs on a second mortgage.
What if I Don’t Qualify To Refinance My Home Equity Line of Credit (HELOC)?
Loan modification may be your only option if:
- You are underwater on your mortgage
- Your credit score has dropped below 620
- Your income is too low to make the monthly payments on a new loan
To apply for a loan modification, which can help you avoid foreclosure by changing your existing loan so that the payments fit your budget, contact your loan servicer and explain your situation. Earlier is better, ideally before you’ve missed a single payment.
Lenders aren’t required to modify your loan, so this option might not be available. If it is, you may have to complete a three-month trial period demonstrating that you can make the altered payments before your servicer officially modifies your loan. Your lender may report the modification to the credit bureaus, causing your credit score to drop. Still, if the alternative is foreclosure because you can’t repay your loan, it’s a small price to pay.
Can I Take Out a Personal Loan To Refinance My HELOC?
Yes, if you can get approved for a personal loan that’s large enough to pay off your HELOC. A personal loan might be a good choice because it’s not secured by your home, and the rates can be surprisingly low if you have excellent credit. Shop around with several lenders to find the best deal. The downside is that the term may be much shorter, which can mean a higher monthly payment (but less interest in the long run).
What if you only qualify for a smaller personal loan that will pay off only part of your HELOC? It still might be worth it because the personal loan will give you a fixed monthly payment for which you can predictably budget. You’ll be carrying less variable-rate debt, so you’ll face less payment uncertainty.
What Happens if I Can’t Repay My HELOC?
Your home is collateral for your HELOC. This means that your loan servicer can foreclose on your home if you can’t repay your loan. Foreclosure can be expensive, and if your HELOC is a second mortgage, then the investors who own your first mortgage would get repaid from a forced sale of your home before the investors who own your second mortgage got anything. If you have little or negative home equity, the second mortgage investors might not see any proceeds from the sale.
As a result, loan servicers aren’t necessarily quick to foreclose on borrowers who can’t repay their HELOCs. They may work with you on a loan modification, but if you can’t afford that, you could still lose your home. Depending on your state’s laws, the second lien holder could sue you if the foreclosure sale doesn’t bring in enough funds to pay off your HELOC.
The Bottom Line
You may get more affordable monthly payments on your HELOC through refinancing, whether into a new HELOC, a home equity loan, or a new first mortgage. Explore your options by applying with several lenders and comparing their offers. See which possibility gives you the best combination of short-term affordability and long-term stability. If refinancing isn’t an option, ask your servicer about a loan modification.