With mortgage rates at historic lows, refinancing is on many people’s minds. Reducing your interest rate can help lower your monthly payments. A lower interest rate may also allow you to shorten your term without significantly increasing your monthly payments, meaning you’ll pay less in interest and build equity faster.
Now, a lower interest rate can save you big, but refinancing a mortgage has a cost, too. Closing costs are part of any mortgage, even when you’re refinancing. Those costs vary but are typically 2% to 6% of your loan amount. Is it still worth it? As long as you’re getting enough of an interest rate reduction, yes. And we can walk you through the math to help figure out if refinancing your mortgage makes sense for you. There is another option for you to consider, though …
A Mortgage Alternative
Did you know you don't have to have a mortgage at all? You could replace it with a home equity loan. Instead of paying those expensive closing costs, the only fee for a GOLD Home Equity Loan is a mortgage recording fee which is typically under $100. While home equity loans are usually taken as a second lien against a home as a low-interest source of cash, they can be the first lien, too and totally replace your mortgage.
“So, interest rate savings plus no closing costs, why doesn’t everybody just do the home equity loan instead of a mortgage?”
Who Can Take a Home Equity Loan in Place of a Mortgage?
While a great option, replacing a mortgage with a home equity loan isn’t the right choice for everyone. There are some conditions you’ll need to meet to go this route.
You Need to Have at Least a Little Equity
The Loan-to-Value Ratio (or LTV) is the amount you owe on your loan divided by the value of the home. The equity is the value above what you owe. While lender requirements vary, you typically need to have at least 10% equity to be able to take out a home equity loan. 80% or 90% are common maximum LTVs on home equity loans.
As an example, if you owe $240,000 on a home valued at $300,000, your LTV is exactly 80%. If you owed $270,000 on the same home, your LTV would be 90%. If your LTV is higher than the lender’s max, it won’t be an option for you right now. At GOLD, our home equity loans go up to 80% LTV.
You Need to be Comfortable with a Shorter Term
Terms, too, vary by lender, but unlike mortgages that extend out to 30 years—the term most home owners have on their mortgage—home equity loan terms are usually not more than 15 years, with some lenders (GOLD included) offering a longer 20-year term.
Still, if you’re just a couple years into a 30-year term, refinancing into a 20-year term is a big difference and will increase your payments. The benefits of a shorter term on reducing your total interest and getting your loan paid off faster are awesome, but only if the larger payments fit into your budget.
You Need to Handle Tax & Insurance Payments Differently
Mortgage loans usually include an escrow account that you pay into with each mortgage payment. The money in that escrow account is then used to pay property taxes, school taxes, and your homeowners insurance premium when they come due annually. You pay a regular amount each month toward them instead of owing a large lump sum when the bill is due.
Most home equity lenders don’t offer a built-in escrow account along with the loan, so you’ll need to plan for paying those annual bills yourself. If you’re comfortable just paying the lump sums as they come due, there’s nothing to do but wait for the bills to arrive and pay them on time. However, most of us need a little more pre-planning to fit such large bills into our budgets. One great method is to set up a separate savings or checking account to act as a DIY escrow account.
Set up automatic transfers to put money into your account monthly or every time you get paid. How much should you transfer? Add up all your annual home bills (you could even include non-home bills like annual auto insurance if you want; it’s your account!) then divide the total by 12 to get the amount you need to deposit each month. If you’re depositing twice a month, divide by 24, or for bi-weekly deposits, divide by 26.
Now, in 12 months’ time, you’ll have deposited enough to pay all those bills but some of them will be due before then. How do you pay them? The same way your mortgage escrow would have—prefund it. Escrow account funding is one of your standard closing costs, but you’ve already got it this time. When your mortgage is paid off, you should get a check refunding the amount from your old escrow account. Put that money into your new DIY escrow account and voila, the account is prefunded.
The best part? Because you own the account, the money can earn interest for you while it sits waiting to pay your bills. A lot of people actually prefer not to have a traditional escrow account for this very reason. They want their money working for them, not earning interest for their loan servicer.
Interest Works Differently in a Home Equity Loan
“But Darian,” you might be saying, “you had me convinced until I saw home equity rates are higher than mortgage rates. The whole reason I want to refinance is for a lower rate!”
Yes, home equity rates tend to be a little higher than mortgage rates, but making the switch to a home equity will still save you. Why?
Most people still have enough time left on their mortgage that refinancing as a shorter-term home equity means the loan will be paid off 5+ years faster, saving on interest overall.
Mortgage loans are repaid with the interest front loaded. That means that at the beginning of your loan, you pay a lot toward interest and make slow progress on paying down principal. Toward the end, you pay very little interest and most of your payment goes toward the principal.
Home equity loan interest isn’t front-loaded. That means you build value in your home faster and, if you sell in a few years, you get more of what you paid into the house back because it didn’t go to interest.
Is a Home Equity Loan a Good Fit for You?
When it comes down to it, the best loan option—mortgage, home equity, or anything else—is the loan that meets your needs and will help you reach your goals. I hope this post gave you some insight into the home equity option, but a blog post alone isn’t enough to make such a big decision. That’s why we’re here!
Give our lending team a call to go over the specifics of your loan and talk about whether refinancing into a GOLD Home Equity Loan is the right choice for you. We’re here to take your call Monday through Friday, 8:30 AM to 5:00 PM at 484-223-4216.