Refinancing your mortgage doesn’t necessarily mean sacrificing home equity. On the contrary, the primary aim of refinancing is typically to secure a new loan at reduced interest rates, facilitating easier repayments and potentially accelerating equity accumulation.
Nevertheless, refinancing can potentially lead to long-term financial losses if approached without caution, and the process itself can impact your overall home equity. Before committing to refinancing, it’s crucial to consider several factors to safeguard the equity you’ve worked hard to build.
How does refinancing affect the equity you have in your home?
Typically, no. If your home is appraised at $300,000 and you still owe $150,000 on your mortgage, refinancing doesn’t alter the fact that your home is valued at $300,000.
However, refinancing can potentially affect your home equity depending on several factors. Your home equity is determined by the difference between your mortgage balance and your home’s current value. During refinancing, costs such as closing fees can be rolled into the new mortgage rather than paid upfront, increasing your mortgage balance and reducing your equity.
Another factor is a cash-out refinance, where you withdraw equity as a lump sum, increasing your loan balance and reducing your equity accordingly.
Conversely, refinancing to a shorter loan term, such as moving from a 30-year mortgage to a 15-year mortgage, can build equity faster. With a shorter term, you pay off the principal more quickly, thereby increasing your ownership stake in the home over time.
Straight refinance vs. cash-out refinance
There are two primary methods to refinance your mortgage: a straight refinance and a cash-out refinance.
Straight refinance: Also known as a rate-and-term refinance, this option involves borrowing the exact amount you currently owe on your mortgage. The goal is to secure a lower interest rate compared to your existing loan, allowing you to pay off more of the principal with each payment. Faster repayment accelerates the growth of your home equity over time, making a straight refinance beneficial for increasing equity.
Cash-out refinance: In contrast, a cash-out refinance poses more risk and can significantly reduce your home equity. With this type of mortgage, you borrow additional funds beyond your current mortgage balance, tapping into your home’s equity as collateral for a lump sum. Essentially, you convert some of your equity back into debt.
While the cash from a refinance can be used for various purposes, it’s typically advisable to invest it in home improvements or repairs that enhance your home’s value and thereby replenish your equity. Otherwise, you diminish your equity substantially, and it may take years of mortgage payments or a substantial increase in property values to rebuild it.
What happens to your home’s equity when you refinance?
Refinancing has the potential to affect your home’s equity positively or negatively. It’s crucial to account for lender fees, closing costs, and accurately assess your home’s current value. Here are the primary ways refinancing can impact your home’s equity:
Lender appraisal
When applying for a loan, lenders conduct an appraisal to assess your home’s current market value. It’s crucial to be aware of any changes in your home’s value since the last appraisal. The appraised value directly impacts several aspects of your refinancing:
- New Mortgage Size: The appraisal determines the size of your new mortgage, based on the current market value of your home.
- Equity Value: Your home’s appraised value affects the calculation of your equity stake—the difference between your home’s value and the mortgage balance.
- Cash-Out Refinance Considerations: For cash-out refinancing, the appraised value determines how much cash you can receive by borrowing against your home equity.
Appraisers evaluate various factors including your property’s age, size, and features like number of rooms. They also consider neighborhood aspects such as crime rates, school quality, and proximity to local services like fire stations. Comparing your home to recently sold properties of similar size in the area helps determine its market value.
Incorrectly estimating your home’s value during refinancing decisions could lead to financial losses or missed opportunities for lower interest rates. Being well-informed about your home’s current market worth ensures you make informed decisions during the refinancing process.
Fluctuating property values
Determining your home equity starts with assessing the total value of your property. The real estate market is dynamic, and your home’s appraisal can fluctuate due to market changes. These fluctuations directly impact the value of your home equity. It’s essential to stay informed about market forecasts and trends to anticipate how your home’s value may be influenced before committing to additional home loans.
Closing costs
If you choose not to pay closing costs upfront, many lenders offer the option to add these costs to your refinance loan amount. For instance, if your refinancing closing costs amount to $5,000 and you’re refinancing $150,000, the lender can increase your loan to $155,000. This amount is borrowed against your home’s value, resulting in a reduction of your equity by $5,000.
Why it’s important to consult with multiple lenders before refinancing
Like any other loan, refinance rates and costs can vary significantly between lenders. It’s wise to consult with several lenders before committing to a refinance. This approach can provide a clearer understanding of the typical refinance expenses and help you secure the most favorable terms.
“Before you start comparing lenders, it’s essential to run the numbers through a mortgage refinance calculator,” suggests Bell. “This tool can estimate your potential savings or costs from refinancing. While securing a lower interest rate and monthly payment may seem enticing at first glance, it’s crucial to consider your plans for the future. If you anticipate moving within the next few years, the immediate savings may not outweigh the total loan costs.”
What to consider before refinancing your mortgage
When you refinance your mortgage with a new loan, your home’s equity remains unaffected initially. However, it’s crucial to monitor fluctuating home equity values, which reflect changes in residential real estate prices and overall property values. Recent years have shown significant volatility in this regard.
For instance, the rapid increase in home prices driven by the pandemic led to a surge in home equity values, reaching a peak in the third quarter of 2021. Subsequently, as rising interest rates began to cool the housing market in mid-2022, home equity growth slowed and even experienced a year-over-year decline in the first quarter of 2023 — the first such decline since 2012.
Nevertheless, by the third quarter of 2023, the housing market started to rebound, and home equity values began to rise again. According to data from property analyst CoreLogic, homeowners with mortgages in the United States saw their equity increase by a total of $1.5 trillion as of the first quarter of 2024, marking a 9.6 percent increase compared to the previous year.
Several social and economic factors influence property values and consequently affect your home’s equity. These factors include unemployment rates, interest rates, crime rates, and changes in zoning regulations in your locality. Real estate typically appreciates over the long term, but this appreciation can be slow and uneven. Moreover, property values can vary significantly from one region to another.
Regardless of the current housing market conditions, it is crucial to accurately assess your home equity before proceeding with refinancing or obtaining any loans against your home’s value. Failing to do so could result in overpaying for refinancing your mortgage or missing out on potential savings if you underestimate your equity. Conversely, overestimating your equity might lead to falling short of your financial needs.
How much equity do I need to have in my home to refinance?
To refinance a conventional mortgage, it’s typically necessary to have at least 20 percent equity in your home. This means your current mortgage balance should not exceed 80 percent of your home’s appraised value, a concept known as an 80 percent loan-to-value (LTV) ratio.
Government-backed loans such as FHA, VA, and USDA may have different requirements. For instance, FHA streamline refinances and VA loans might not mandate an appraisal, allowing refinancing even with little or negative equity.
“If you’re uncertain about your equity position or which refinancing option suits you best, it’s advisable to consult with a mortgage professional,” suggests Bell. “They can provide personalized guidance and assist you in making the optimal decision for your home and financial situation.”
Home equity loan vs. refinancing: What’s the difference?
Refinancing isn’t your sole option for accessing home equity. So, what sets apart a home equity loan from a cash-out refinance?
Both involve leveraging your home as collateral for debt. However, a cash-out refinance entails securing a new mortgage. It’s advantageous when interest rates drop below those of your initial loan, potentially allowing for a change in loan terms. It’s ideal for consolidating payments or reducing long-term interest costs.
On the other hand, a home equity loan, often termed a “second mortgage,” leaves your original mortgage intact while adding a new debt based on your home equity. This results in managing two separate monthly payments. Yet, it preserves your existing mortgage interest rate, making it a viable choice in certain circumstances.
Can I still take out a home equity loan after I have refinanced my home?
It’s still feasible to secure a home equity loan post-refinancing, contingent on having sufficient equity in your home. Lender approval hinges on the equity percentage in your property, typically requiring 15 to 20 percent.
If refinancing reduces your available equity below this threshold, you might need to postpone obtaining a home equity loan until you’ve paid down more of your mortgage balance. Typically, most home equity loan applicants are at least one-third into their mortgage terms, having accrued significant ownership stake.
In Conclusion
Refinancing initially leaves your home equity unchanged, but various factors can influence your home’s value over time, potentially impacting your equity. It’s crucial to recognize that your equity is a theoretical value until you sell your home and realize the cash. Therefore, your equity position can fluctuate based on local home prices and mortgage balances.
Before committing to a refinance, ensure you know your home’s current appraised value. Compare mortgage refinance rates and APRs, which encompass lender fees and closing costs. This approach helps ensure that any refinancing decision you make enhances your position in the home equity arena.