Can You Refinance With Less Than 20% Equity?

Many homeowners believe that having at least 20% equity is required to refinance a mortgage. Refinancing a home loan with less than 20% equity is possible through various pathways. Understanding these options helps homeowners seeking to lower interest rates, adjust loan terms, or achieve other financial objectives.

Understanding Home Equity and Refinance Goals

Home equity represents the portion of your property that you truly own, calculated as the home’s current market value minus any outstanding mortgage balances or other liens. As you make mortgage payments, a portion goes towards reducing the principal, thereby increasing your equity. Property value appreciation also contributes to equity growth, while a decline in market value can reduce it.

A key metric in mortgage lending is the Loan-to-Value (LTV) ratio, which compares the amount owed on a mortgage to the home’s appraised value. For instance, if your home is valued at $300,000 and you owe $240,000, your LTV is 80%. An LTV ratio greater than 80% signifies that you have less than 20% equity, indicating a higher perceived risk for lenders. Homeowners typically consider refinancing for several reasons, including securing a lower interest rate, reducing monthly payments, shortening the loan term, or converting an adjustable-rate mortgage to a fixed rate. Some also refinance to consolidate debt or access cash from their home equity for other financial needs.

Government-Backed Refinance Pathways

Several government-backed programs offer refinance opportunities for homeowners with limited equity. These options provide more flexible eligibility criteria than conventional loans, making refinancing accessible. They aim to help borrowers improve their loan terms.

FHA Streamline Refinance

The FHA Streamline Refinance is designed for homeowners with existing FHA-insured mortgages. This program is streamlined because it typically avoids a new appraisal, credit check, or extensive income verification. To qualify, you must have an existing FHA loan, be current on your payments with no more than one 30-day late payment in the past year, and the refinance must result in a “net tangible benefit.” This benefit usually means a reduction in your combined interest rate and mortgage insurance premium (MIP) by at least 0.5 percentage points, or converting from an adjustable-rate to a fixed-rate mortgage.

VA Interest Rate Reduction Refinance Loan (IRRRL)

For eligible veterans, the VA Interest Rate Reduction Refinance Loan (IRRRL) facilitates refinancing an existing VA loan. This program helps veterans secure a lower interest rate or move from an adjustable-rate to a fixed-rate mortgage. A key feature of the VA IRRRL is that it generally does not require an appraisal or credit underwriting. Borrowers must have an existing VA loan on the property and certify that they previously occupied the home. The loan must also provide a net tangible benefit, such as a lower interest rate or a more stable payment structure.

USDA Streamline Refinance

The USDA Streamline Refinance is available to homeowners with existing USDA rural development loans. Similar to FHA and VA streamline programs, this option assists eligible rural homeowners in refinancing their mortgages. It focuses on reducing the borrower’s interest rate and monthly payments. Eligibility typically requires the homeowner to have an existing USDA loan, demonstrate a good payment history, and show that the refinance will result in a net tangible benefit, such as a lower payment.

Conventional Refinance with Low Equity

Conventional loan options also exist for refinancing with less than 20% equity, though they often involve private mortgage insurance (PMI). PMI is an insurance policy that protects the lender if a borrower defaults on a conventional loan where the loan-to-value (LTV) ratio exceeds 80%. While the borrower pays for PMI, its primary purpose is to mitigate the lender’s risk associated with a smaller equity stake.

PMI payments are typically structured as monthly premiums added to your regular mortgage payment. The cost of PMI can vary, usually ranging from 0.5% to 1.5% of the loan amount annually, influenced by factors like your credit score, loan amount, and LTV ratio. Although PMI adds to the monthly housing expense, it makes conventional financing accessible to those who do not have 20% equity.

The Homeowners Protection Act (HPA) of 1998 provides specific rules for the cancellation of PMI. You can typically request to cancel PMI once your loan balance reaches 80% of the home’s original value. Lenders are generally required to automatically terminate PMI once your loan balance reaches 78% of the original value, provided the loan is current. Some lenders may also allow for earlier cancellation if your home’s value has significantly appreciated, leading to an LTV of 80% or below based on a new appraisal.

Preparing for Your Refinance Application

Before initiating a refinance application, gather and organize necessary financial information. This streamlines the process and demonstrates your readiness to lenders.

Lenders will require various financial documents to assess your ability to repay the new loan. This includes income verification, typically through pay stubs from the last 30 days, W-2 forms from the past two years, and federal tax returns for the previous two years. For self-employed individuals, two years of tax returns with all schedules and year-to-date financial statements are commonly requested. Asset statements, such as bank accounts, investment accounts, and retirement account statements from the most recent two months, are also necessary to verify your financial reserves.

Understanding your credit score and history is important before applying. Lenders use your credit report to evaluate your creditworthiness and payment history, which influences the interest rate and loan terms. Reviewing your credit report beforehand allows you to identify and address any inaccuracies. Property-related information will also be needed, including your current mortgage statements, recent property tax bills, and homeowner’s insurance policy details.

The Refinance Application and Closing Process

Once you have gathered all necessary information, the refinance journey typically begins with a pre-qualification or pre-approval stage, where a lender provides an initial assessment of your eligibility. This step helps you understand potential loan amounts and interest rates. Following this, you submit a formal application, providing all the prepared financial and property documents for a thorough review.

After application submission, the loan moves into underwriting, where the lender evaluates your credit, assets, income, and the property’s value to determine final approval. An appraisal of your home is often required to confirm its current market value, though some streamline programs may waive this. If the appraisal supports the loan amount and all conditions are met, the loan receives final approval.

The concluding phase is the loan closing, where all parties sign the final paperwork. This typically occurs at a title company or attorney’s office. During closing, you will pay various costs associated with the refinance, often ranging from 2% to 6% of the loan amount. These closing costs can include origination fees, appraisal fees, title insurance, recording fees, and attorney fees. After signing, there is typically a three-business-day rescission period during which you can cancel the new loan, after which the refinance officially takes effect and your old loan is paid off.