How Much Equity Do I Need to Refinance?

Summary:

Your home is a major purchase, and your mortgage is likely the largest loan you have. Refinancing for better terms, which can include lower monthly payments, can save you significant money over the life of your loan. Popular advice is to have at least 20% equity in your home before refinancing so you can qualify for better rates and get rid of private mortgage insurance if you have it.

In this article:

When can you refinance a home?
What is home equity?
What is loan to value ratio?
How much equity should I have?
How to refinance a house
Consider the costs

Home refinancing can help you reduce your mortgage payments or leverage the value of your home to pay off debts. Your home equity is the key to refinancing — both the amount you can refinance and what kind of interest rates you may be offered.

You may need to wait until refinancing makes financial sense. If national interest rates have gone down and your credit score has improved since you took out your mortgage, you may be eligible for a mortgage interest rate that is lower than your current rate, which can save you money.

When can you refinance a home?

When you can refinance your mortgage depends on the type of your mortgage and the type of refinance. For conventional mortgages and with a simple change in the rate and term of your refinance, you can typically refinance at any time. If you have a government backed mortgage or are looking for a cash-out refinance, during which you convert some of your equity into cash, you may need to wait at least a year or more. Talk to your lender about refinance requirements if you have any questions.

What is home equity?

Equity represents the portion of your home that you own yourself. Think of it as the amount you would get if you sold it today minus your mortgage. For example, if your home is worth $300,000 and you have a remaining mortgage of $225,000, then your home equity would be:

Home value:  $300,000
Outstanding mortgage:  $225,000
Home Equity:  $300,000 - $225,000 = $75,000

So, in this case you’d have $75,000 in home equity which is built up through your mortgage payments and any home appreciation.  Expressed as a percentage, you’d have 25% equity in your home ($225,000/$300,000). Generally, the higher the equity, the easier it is to qualify for a loan.

What is loan-to-value ratio?

Home equity is closely related to the loan-to-value ratio, or LTV, an important calculation that lenders use when evaluating mortgage applications. You can calculate LTV yourself by dividing your mortgage balance by your home’s current value.

LTV = Mortgage balance / Home Value

For example, if you want to refinance your home with $300,000 current market value with a $225,000 mortgage balance, your LTV would be: 

LTV:  $225,000 / $300,000 = 0.75 or 75%

Think of LTV as an inverse of equity — the lower your LTV ratio, the more equity you have in your home. In fact, your home equity percentage is simply 100% minus the LTV percentage:

Home Equity % = 100% - 75% = 25% 

Lenders generally look for an LTV ratio of 80% or below, as a smaller ratio represents a lower level of risk. Understanding and building home equity is vital in order to increase your odds of doing a refinance on your mortgage.

How much equity should I have?

Refinance requirements can differ depending on the lender, type of loan you have and your personal circumstances but having 20% equity in your home is typically advised for conventional mortgages. Refinancing with at least 20% equity can help you avoid mortgage insurance payments. For government backed loans, like FHA, VA, and USDA backed mortgages, refinance requirements, including the amount of equity needed, can be different. Government loans typically have approved lenders you can work with to refinance. You can speak to a lender if you have any questions about government backed mortgage refinance requirements.

How to refinance a house

When you refinance your mortgage, you’re replacing your current mortgage with a new one. Your new lender pays off the balance of your current home loan. Ideally, the new mortgage has more favorable terms for you, like a lower interest rate.

Here are some of the steps involved in refinancing your mortgage:

Evaluate your current mortgage

Do due diligence not just on your new mortgage, but your current one too.

• Is now a good time to refinance?
• What is the interest rate?
• Are there any fees for early repayment?
• How much do you pay in mortgage insurance if you have it?

There may be special considerations if your current mortgage is backed by the government. Knowing your current loan terms will help you determine if you’re making the best decision.

Check your credit report

Lenders will check your credit health to ensure there have been no changes since you secured your original mortgage. If your credit score is healthy and your total debt hasn’t increased substantially, it’s a good sign to lenders that you will be able to manage your new mortgage. The better your credit score, the better your odds at securing the best terms possible. You can get a free credit report weekly from each of the three national credit reporting agencies (TransUnion, Equifax, and Experian) at annualcreditreport.com

Don’t just check your credit score but be sure to fully read your credit reports. (For explanations on important sections, read our tutorial on how to read a credit report).  Be on the lookout for any signs of fraud. Checking your credit report well in advance of refinancing will give you time to spot inaccuracies, as well as information you may not recognize.

If your credit isn’t as healthy as you’d like, it may make sense to hold off on refinancing so you can work on better credit habits. Keeping up with your credit health, knowing how it may change and how to rebuild credit can help greatly when deciding when to refinance.

Shop around for lenders

You don’t need to settle for your current bank or credit union when you refinance, though they can be good places to start. Research different banks, credit unions and online lenders and compare interest rates, fees and terms. If your credit is healthy, you’ll have many lenders competing for your business. Find the lender most suitable to your needs. You can get preapproval quotes from multiple lenders to compare which is offering the best terms. When shopping for rates, be sure to bunch your applications into a short window to avoid multiple hard inquiries that can ding your credit score.

Gather necessary documents

Just like when you got your original mortgage, there can be paperwork involved. Preparing documents ahead of time can help make the process more efficient. Lenders may have different requirements, but you can start gathering proof of income, like pay stubs, recent tax returns and bank statements to get started.

Apply for refinancing

When you find the lender that’s right for you, you can start the application process. This is when you’ll need to provide detailed information about your financial status and provide any necessary supporting documents. It can feel tedious, but the more you prepare ahead of time the easier and faster it will go. The lender will usually require a new home appraisal after you apply. Home conditions and your local market can change over the years, so they are trying to get an accurate picture of your home’s current value.

Closing your loan

If you’re approved, you’ll set a closing date with your lender, which is when you sign your final loan documents. This is when you’ll need to pay your closing costs if they aren’t included in your new loan.

These costs typically include fees such as:

• Appraisal
• Underwriting
• Title services
• Origination charges
• Prepaid taxes and insurance
• Other fees

According to Fannie Mae, refinancing closing costs can range from 2% to 6% of the total loan amount. Make sure that you weigh the potential benefits against these fees. It takes time to recoup the refinancing costs incurred.

You’ll receive a disclosure before your closing date so you can carefully go over the numbers again. After signing, you have a three-day grace period before your loan is funded. This gives you the opportunity to cancel your new loan should you need to.

Consider the costs

The steps above cover some of the basics of refinancing, though the process can vary based on your current and your new loan, the lender you’re working with and your current financial status. If you have any questions throughout the process, stay in contact with your lender. Ask as many questions as you need to feel comfortable.

Be sure to carefully consider the costs and potential savings when refinancing. Your home is likely one of, if not, the biggest purchase you’ll ever make. Taking advantage of opportunities to lower its total cost and your loan terms can be a smart financial move.