Home refinancing is often a good way to 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. If you’re wondering how much equity you need, here are some general guidelines.
Understanding Equity and LTV
Equity represents the portion of your home that you own yourself; that is, the amount you would get if you sold it today minus your mortgage. For example, if your home is worth $100,000 and you have a mortgage of $75,000, then you have a 25 percent equity in your home. Generally, the higher the equity, the easier it is to get a loan. The general rationale behind this is that the larger your personal stake is, the less likely you are to default on your loan payments.
A key factor for lenders in determining whether you’ll be approved for a home equity loan is your home’s loan-to-value ratio, or LTV. If you are dealing with a lender who talks about LTV, you can calculate LTV yourself by dividing your mortgage by your home’s value. For example, a $100,000 home with a $75,000 mortgage has an LTV ratio of 75 percent. Lenders generally look for an LTV ratio of 80% or below, as a smaller ratio represents a lower level of risk. Think of LTV as an inverse of equity — the lower your LTV ratio, the more equity you have in your home.
The 20 Percent Equity Rule
When it comes to refinancing, a general rule of thumb is that you should have at least a 20 percent equity in the property. However, if your equity is less than 20 percent, and if you have a good credit rating, you may be able to refinance anyway. In this case, the lender may charge you a higher interest rate or make you take out mortgage insurance.
Refinancing With Mortgage Insurance
Mortgage insurance is a requirement for those with less than 20 percent equity in their homes to protect the lender in case the homeowner defaults on loan payments. The insurance premiums are paid by the homeowner, either in monthly payments or upfront in a single payment. Provided you’re not taking cash from the loan, which is known as cash-out refinancing, you may be able to refinance up to 95 percent of the home’s value on a conventional mortgage with mortgage insurance.
Refinancing With the FHA
If you have a low credit score, or a small amount of equity in your home, you may want to refinance your mortgage through the Federal Housing Administration, or FHA. These are loans through approved lenders that are backed by the government. Interest rates are competitive, but not as flexible, and the maximum loan amount can vary by county. If you are eligible, you may be able to refinance as much as 85 or 95 percent of your home’s value.
Equity and Appraisals
Before determining whether or not you’re eligible for refinancing, the lender will need an appraisal of the property’s value. The appraisal determines what a buyer would reasonably pay for the property if you sold it today.
If you are refinancing through the FHA, an appraisal also takes into consideration the health and safety of the home. Roof leaks, missing handrails or ventilation issues, for example, may affect the appraisal.
If you aren’t certain whether or not you have enough equity in your home for mortgage refinancing, make sure you understand what fees you’ll have to pay when applying for a loan, which may range from $300 to $800. If in doubt, check out what similar homes in your neighborhood are selling for before paying the fees.