Options for Refinancing Your HELOC

If you have a home equity line of credit (HELOC) that’s nearing the end of its draw period and about to enter its repayment period, brace yourself: You could be in for much higher monthly payments. That’s because your new payments will consist of both principal and interest, unlike the interest-only (or interest plus a small amount of principal) payments your lender likely required during the draw period.

There are several ways to deal with this situation if the new payments prove to be a problem. This article explains your major options and their pros and cons.

Ways to Refinance Your HELOC

If you’re looking to refinance your HELOC, you might do so with a new HELOC, a home equity loan, or a new first mortgage. Here are the basics of each option.

1. Refinance With a New HELOC

How It Works: If a lender (either your current bank or a different one) approves your application for a new HELOC, you may be able to roll your existing HELOC’s balance into it. This essentially restarts your draw period.

Pros: Taking out a new HELOC allows you to put off those larger payments you were facing for another five or 10 years, or whatever draw period the lender agrees to. This might make sense if you are reasonably confident that you’ll be in a better financial position when the new HELOC goes into repayment mode and won’t have a problem with the new payments. You might also be able to switch from a variable-rate HELOC to one with a fixed-rate option.

Cons: All you’re really doing here is postponing the inevitable: At some point you’ll need to repay your entire balance. What’s more, since interest will be accumulating all the while, your payments will be even higher than the ones you’ve managed to avoid.

2. Refinance With a Home Equity Loan

How It Works: You take out a home equity loan and use it to pay off your HELOC in a lump sum.

Pros: A home equity loan has several potential advantages over your home equity line of credit. One is that these loans typically have fixed interest rates, while HELOCs usually come with variable rates. A fixed rate gives you predictability for budgeting purposes as well as some protection against rising rates. In addition, home equity loans often have terms (lengths) of up to 30 years, giving you a longer time to repay than a HELOC, which usually allows 20 years at most.

Cons: As with a new HELOC, taking out a home equity loan to repay your HELOC means that your debt will continue to grow. What’s more, home equity loans generally require you to make both principal and interest payments for the entire term, so you could be faced with higher payments from the outset.

3. Refinance With a New First Mortgage

How It Works: You take out a new mortgage to refinance both your existing first mortgage and the HELOC. One way to do this is through a cash-out refinance. With a cash-out refinance you take out a mortgage that’s larger than your current mortgage balance, pay off that balance, and then use the remaining cash for whatever you wish. In this case that would be paying off the HELOC.

Pros: The interest rates on primary mortgages tend to be lower than those on HELOCs or home equity loans, so you could see substantial savings right there. You can opt for a mortgage with a fixed rate if you wish, and terms of up to 30 years are common.

Cons: Depending on the prevailing rates when you apply, you might have to accept a higher interest rate on the new mortgage than you had on your old one, making it more expensive. In addition, closing costs on a mortgage can be substantial—often 2% to 5% of the total loan amount on top of your down payment. With a $300,000 mortgage, for example, that’s $6,000 to $15,000. Some lenders will cover your closing costs if you take out a HELOC.

How to Qualify to Refinance Your HELOC

Whatever method you use to refinance, the lender will want to assure itself that you’re a good risk. For starters, any lender you apply to is likely to review your credit report and check your credit score.

As a general rule, you’ll need a FICO score in the 700s or high 600s to qualify for a good rate. You may need a score of at least 620 to qualify at all.

The lender will also want information on your income (which is not included in your credit report). So you might have to provide pay stubs, W-2 forms, and one or more recent tax returns, among other documentation.

Based on that information and a list of your current debt payments, the lender will calculate your debt-to-income (DTI) ratio. That ratio compares your gross income to your total monthly debt obligations to make sure you aren’t getting in over your head. Many lenders like to see a DTI no higher than 36%.

Of course, the home itself also comes into the picture. Lenders will typically require a new appraisal to determine its fair market value. They’ll use that to compute your combined loan-to-value (CLTV) ratio, which compares how much you owe on the home to its current value. Lenders generally prefer that your CLTV (including any new loan) not exceed 80% or 85%.

The Bottom Line

If the monthly payments on your HELOC become unmanageable, refinancing it could be your best recourse. There are a number of ways to go about it, each with their own pros and cons. If you find you can’t qualify for a new HELOC or other loan for whatever reason, contact your current lender and ask if a loan modification is possible. It is often in the lender’s best interests, as well as yours, to modify your HELOC to make your monthly payments affordable.