Kevin Mercadante June 23, 2016
If you have a home equity line of credit, or HELOC, you may be considering whether you should refinance it with better terms and a better interest rate. That’s an especially important consideration since HELOCs don’t work like traditional loans.
Here’s a recent question we received on this exact topic from a reader named Gale:
I thought that you’d like to know that we took your recommendation for cell phone service from Republic Wireless. We bought their cheapest phones and now only pay $23.50 a month for 2 phones with unlimited service compared to around $43 something a month from Verizon. That’s a savings of $240 a year. Now I’m trying to decide how to pick a financial institution to refinance a home equity loan? Comparing rates is tough when they are going ding our credit score. Any suggestions?
Unlike mortgages, where rates and loan terms are standard across the industry, HELOCs offer rates that can vary widely due to a number of factors. Although most mortgages are bought and sold by government agencies such as Fannie Mae and Freddie Mac, HELOCs are offered directly through banks. Because of this, the terms and interest rates offered tend to be all over the map.
The Effects of HELOCs on Your Credit Scores
Gale’s HELOC question deals in part with the fact that applying for a HELOC could result in a hard inquiry on your credit report. Any time you apply for a new line of credit, there will be consequences. Here are a few reasons your credit score might feel the impact:
Hard inquiries can cause your credit score to drop temporarily.
An inquiry is a notation on your credit report that shows a lender pulled your information in anticipation of granting you a loan. Commonly referred to as a hard inquiry, this notation can have a negative effect on your credit score.
In order to limit the damage, do your research and limit your applications to no more than two or three lenders. The effect of a hard inquiry on your credit score is only temporary, but multiple inquiries can result in a bigger immediate impact.
Opening a new line of credit can impact your score.
Since HELOCs are considered revolving lines of credit, lenders and credit reporting agencies treat them more like a credit card than a mortgage product. As a result, the addition of a new HELOC can have a negative effect on your credit score, particularly if the line will be maxed-out from the start. This is the credit utilization ratio, which represents a full 30% of your credit score.
If you are worried that this could be a problem, you may be able to work around it by taking a larger HELOC than you need and accessing the lowest amount possible. This will keep your credit utilization ratio lower, which should lessen the impact on your credit score over time.
Finding the Best HELOC Terms
If you hope to refinance your HELOC into a similar loan with better terms, it’s important to know where to look. Here are a few places to start your search:
Your Current HELOC holder. This is where you should always start. Even though the terms on your current HELOC may be less than ideal, your lender may be willing to offer a new loan if it means keeping you as a customer. You’ll never know unless you ask.
A Local Bank. If your current lender won’t or can’t help you, you should shop around with their competitors. Most banks who offer HELOCs are anxious for new business. You may have to open up another account with a new bank, such as a checking or savings account, but if the numbers on the new HELOC make sense, this may not be a problem.
Credit Unions. Most credit unions are local organizations who are anxious for new customers that might be interested in becoming a “member.” You may have to open an account to take advantage of the low rates that credit unions normally offer, but that extra step could be worth it.
Your Current First Mortgage Holder. Many first mortgage lenders offer HELOCs in addition to their traditional mortgage products. If you’re an existing customer, they may even have preferred pricing, particularly when it comes to upfront costs.
Online Lending Sources. Online sites, such as LendingTree.com maintain lists of HELOC lenders in your local area. At a minimum, this will give you an opportunity to see a list of competitive rates in your area. Even if you don’t use an online lender, you can use the information you gather as a benchmark to determine if any other lender is offering reasonable terms.
Another Option: Refinance Your First Mortgage and HELOC into a New First Mortgage
If you’re willing to think outside of the box, refinancing your first mortgage and HELOC into one loan could be the most lucrative way to make your HELOC go away. Of course, this strategy will only work if you have a considerable amount of equity in your home already. As a rule, you want to make sure that refinancing the combination of the two will not cause the new mortgage to exceed 80% of the value of your home. This will not only make loan approval easier, but it will also eliminate the need for costly private mortgage insurance, also known as PMI.
One drawback to refinancing your first mortgage is the fact you’ll probably need to pay closing costs. However, you can minimize or even eliminate closing costs through the use of premium pricing. This is an arrangement where you accept a slightly higher interest rate in exchange for the lender paying your closing costs for you.
Even though this will not get you back to an interest only payment scheme with your HELOC, it will reduce your monthly housing costs to a single payment. And with 30 year fixed-rate mortgages currently below 4% for thirty-year loans, that new payment might be less expensive than you ever imagined.