5 important home equity loan refinancing requirements to know
In recent years, many homeowners have been hesitant to refinance their home equity loans because loan rates have remained elevated. While the Federal Reserve doesn't set loan rates for mortgage loans, including rates on home equity loans, they tend to rise and fall with the Fed rate. The Fed has held rates at a target range of 5.25% to 5.50% since May 2023, and not surprisingly, home equity loan rates have remained elevated in this high-rate environment. As of August 9, the average rate on home equity loans was 8.59%.
More recently, though, inflation is showing signs of cooling and mortgage rates have started to fall in tandem. Many analysts now anticipate the Fed will lower rates in the coming months, and lenders have started factoring this into their lending rates. That means if you took out a home equity loan at some point in the last couple of years, you may be paying more than you would at today's rates.
As a result, it may be worth considering whether refinancing your home equity loan makes sense. Before you do that, though, it's important to know the requirements that can come with it.
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5 important home equity loan refinancing requirements to know
Don't start the home equity loan refinance process until you're sure you meet these common requirements.
1. Sufficient home equity
Before you get too far along in the process, it's a good idea to verify that you have enough home equity to qualify for refinancing. Home equity is the estimated market value of your home, minus your mortgage balance and any other loans secured by your home.
So, if your home is valued at $400,000 and you owe $200,000 on your mortgage and $50,000 on your existing home equity loan, your home equity is $150,000. In this example, your home equity of 37.5% is well above the 15% to 20% minimum most lenders require to take out a home equity loan.
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2. Strong credit
Credit score requirements vary by lender, but most want a FICO score of 680 or higher when refinancing a home equity loan. That said, some home equity loan lenders have strict credit requirements and require a minimum credit score of 720 while others are willing to work with bad credit borrowers with scores below 680 — especially if you have substantial equity in your home. Generally, however, the higher your credit score is, the better your chances of loan approval and securing favorable terms.
If your credit score is lower than you'd like, it may make sense to try and quickly build your credit score before applying. Even a modest credit bump from the fair credit range (580 to 669) to the good range (670 to 739) could help you qualify for a lower interest rate that saves you thousands of dollars over the life of the loan.
"The easiest way to improve a credit score over a short period of time is to lower your credit utilization," says Ralph DiBugnara, the founder and president of Home Qualified in New York City.
Credit utilization is the amount of your available credit limits you're using on revolving credit, like a credit card or line of credit. Generally, the lower your credit utilization ratio, the better, so paying down your debt balances — or getting credit line increases — may strengthen your credit.
"A good utilization rate that will improve your credit score is below 30%," notes DiBugnara. "If a credit card has a max limit of $1,000, then the debt on it would need to be $300 or under to create an improved score."
3. Sufficient income
Lenders also want to verify your income is strong enough to afford the payments on the new home equity loan you're refinancing with. Your income is also a factor your lender will consider when calculating your maximum loan limit.
As such, be prepared to show pay stubs, W-2s, tax returns and other forms of verification that prove you have enough income to comfortably afford the new loan payments.
4. Low debt-to-income ratio
One of the most important factors home equity lenders consider before approving or denying a loan is your debt-to-income (DTI) ratio. This measurement reveals how much of your monthly gross income must go toward your monthly debts. Lenders typically require a DTI ratio of 43% or less, with lower ratios being more preferable.
"A low DTI shows that the borrower has additional cash flow that can be used for purposes other than debt payments," says Josh Jampedro, CEO of Home Loan Advisors. "This is an indicator of overall financial strength, which is a sign that the borrower will have the ability to repay the mortgage, even if cash flow decreases."
5. Low combined loan-to-value ratio
Lenders also don't want to approve a home equity loan if it would leave a borrower with too much mortgage debt. When reviewing your application, your lender will calculate your combined loan-to-value (CLTV) ratio, which is the combined total of all loans on the property — including the primary mortgage and the home equity loan you're applying for.
This figure is then compared to the property's value to determine the CLTV ratio, which lenders typically require to be below 90%. So, if your home is worth $500,000, your total outstanding mortgage balances should not exceed $450,000 to meet this requirement.
Adam Fingerman, a business analyst at Navy Federal Credit Union, points out that optimizing the value of your home through renovations that enhance curb appeal can improve your ratio.
"Paying down your mortgage balance can be another strategy to improve your CLTV. By reducing your mortgage balance, you're reducing how much you owe, which can reduce your score," Fingerman says.
The bottom line
If you took out a home equity loan with a high rate in the last few years, it may be worth looking at current rates and running the numbers to see how much you might save. If refinancing could work in your favor, consider getting rate quotes from at least three home equity lenders. Every lender sets its own lending criteria and offers different rates and terms, so shopping and comparing home equity loans could help you find the best deal.
