Can You Take Out a Home Equity Loan to Pay Off Mortgage?
Learn how to strategically use your home's built-up value to address your primary mortgage. Understand the methods, costs, and eligibility.
Home equity is the portion of your home’s value that you own. It is calculated as the current market value of your property minus any outstanding loan balances secured by the home. For instance, if your home is valued at $400,000 and you owe $200,000 on your mortgage, you have $200,000 in home equity. This equity grows as you make mortgage payments and as your property’s market value increases. Leveraging home equity is a common strategy to address existing mortgage debt.
Understanding Home Equity for Mortgage Payoff
Home equity can be accessed to “pay off” an existing mortgage, though this usually involves replacing the original mortgage with a new, larger loan. The most common method for this is a cash-out refinance.
A cash-out refinance involves obtaining a new mortgage that is larger than your current outstanding loan balance. The new loan pays off your existing mortgage, and you receive the difference in cash. For example, if your home is worth $450,000 and you owe $300,000, a cash-out refinance might allow you to take out a new loan for $360,000 (80% of the home’s value). After paying off the original $300,000 mortgage, you would receive $60,000 in cash. This cash can then be used for various purposes, including debt consolidation or home improvements.
While less common for fully paying off a first mortgage, a Home Equity Line of Credit (HELOC) or a Home Equity Loan (HEL) could also be used. A HELOC is a revolving line of credit that allows you to borrow as needed, similar to a credit card, while a HEL provides a lump sum. If you have substantial equity, a large HELOC or HEL could be used to pay off the first mortgage. However, HELOCs often have variable interest rates, which introduces more risk compared to a fixed-rate mortgage.
The amount of equity you can access is primarily determined by the loan-to-value (LTV) ratio. This ratio compares the loan amount to the home’s appraised value. For a conventional cash-out refinance, lenders typically require a maximum LTV ratio of 80%, meaning you must retain at least 20% equity in your home. Some government-backed loans, like VA cash-out refinances, may allow higher LTVs.
Financial Implications of Using Home Equity
Leveraging home equity to address mortgage debt involves several financial considerations. A new loan, such as a cash-out refinance, will come with a new interest rate, which may be higher or lower than your original mortgage rate. This new rate directly impacts your monthly payments and the total interest paid over the loan’s lifetime. If the new rate is higher, your monthly payments will increase, and the overall cost of borrowing will be greater.
Obtaining a new loan also involves closing costs. These can range from 2% to 6% of the new loan amount. Common closing costs include origination fees, which are typically 1% to 2% of the loan principal, appraisal fees, usually between $200 and $500, and title insurance fees, which can be 0.5% to 1% of the home’s value. These costs can either be paid out-of-pocket or rolled into the new loan, which increases the total borrowed amount.
Taking on a larger mortgage debt secured by your home increases your financial liability and risk, as your home serves as collateral for the larger loan. The new loan will also have a specific term, such as 15, 20, or 30 years, which influences both your monthly payment and the total interest paid. A longer term generally results in lower monthly payments but increases the total interest over time.
Using your home equity means reducing the amount of equity you have available in your property. While you gain immediate cash, it decreases the portion of your home that you own outright. This can impact your financial flexibility for future needs or reduce the profit you might realize if you sell your home.
Eligibility and Application Process
Qualifying for a loan that leverages home equity to address mortgage debt depends on several criteria lenders assess. A good credit score is generally required, with conventional loans typically needing a minimum score of 620, though higher scores can lead to better interest rates and terms. Some FHA refinance options may allow scores as low as 580, while VA loans often have no set minimum from the VA itself, but lenders usually look for scores around 620 or higher.
Lenders also evaluate your debt-to-income (DTI) ratio, which compares your total monthly debt payments to your gross monthly income. Most lenders prefer a DTI ratio of 36% or less, though some may approve loans with DTIs up to 43%, or even higher for certain government-backed loans. A lower DTI indicates a more manageable debt load and increases your chances of approval.
Your loan-to-value (LTV) ratio is another important factor, determining how much equity you can access. For a cash-out refinance, most lenders require you to maintain at least 20% equity in your home. Stable employment and income verification are also required, with lenders assessing your ability to repay the new loan.
The application process involves several steps and requires specific documentation. You will typically need to provide income verification, such as W-2 forms and tax returns from the previous two years, and recent pay stubs (e.g., past 30-60 days). Bank statements for all financial accounts, usually for the last two months, are also commonly requested to verify assets. Additionally, lenders will ask for property information, including your current mortgage statement and proof of homeowners insurance.
The process generally begins with researching and comparing different lenders to find suitable loan options. You may go through pre-qualification or pre-approval steps, which provide an initial assessment of your eligibility. Once you formally apply, the lender will typically order an appraisal of your home to determine its current market value, which is crucial for calculating your LTV. Your application then moves to underwriting, where your financial information is verified, and a final decision is made. The final step is closing, where you sign the loan documents and pay any remaining closing costs, and the funds are disbursed.