What Happens to Equity When You Refinance

At your mortgage closing, you’ll meet with a number of people as you go through the process of signing documents, making payments, and obtaining the keys to your new home.

During this time, you’ll be asked to approve paperwork such as a deed of trust (or mortgage), a promissory note, and the closing disclosure. It will be up to you to know what’s expected of you at closing and understand certain jargon (or key homebuying terms) as documents are passed between various legal representatives.

The one thing no one is likely to explain? Home equity, including what it is and how you obtain it. In fact, it’s possible that while you heard how equity is one of the main benefits of owning a home, you’ve entered into a mortgage not knowing what it is or why it really matters.

More importantly, what happens to equity when you refinance and your loan terms change?

What Is Home Equity?

Quite simply, home equity is the portion of your home that you can actually say you own. A lender will tell you that equity can be calculated by taking the current value of your home and subtracting the remaining balance on your mortgage.

But wait  — there’s more.

As SmartAsset points out, home equity can also be determined by using the appraised value of your home and deducting the remaining mortgage balance.

Confused?

Let’s say you purchased a $200,000 home several years ago and put $10,000 down (or 5%) at closing. You’ve made your mortgage payments faithfully and the principal balance on your mortgage is currently $184,000. Simple math would have you believe the equity in your home is now $16,000, and that math would hold up.

But what if you have the property reappraised and market conditions reflected an increase in value? If the appraisal comes back at $206,000 then what you really have is $22,000 in equity.

At this time, it’s important to understand that home equity can change (and move both up and down) depending on the market and your current mortgage terms.

Using Home Equity

As you’ve probably figured out, your home equity will continue to increase as long as you pay down your loan balance or the home increases in value. As long as both of these situations remain true, equity will be an asset and can be considered a part of your net worth.

Consequently, you can begin to treat the equity in your home like cash and take a partial or lump sum withdrawal if you need it. Some homeowners eventually apply for a home equity line of credit, or HELOC. Others take out a home equity loan (commonly known as a second mortgage).

According to The Balance, both of these loan types are popular and tempting to homeowners because they provide access to a large sum of money at low-interest rates. 

A third option to take advantage of your home equity involves refinancing.

Equity and Refinancing

Refinancing your home can mean trading one loan for another with better terms, or cashing out some of the equity you hold in the property. The caveat in a cash-out refinance is that your equity will drop since you’re obtaining a brand new mortgage and taking out cash at closing.

In the above example, the first type of deal is referred to as rate-and-term financing. Most homeowners pursue this type of refinance if their current mortgage loan carries a high-interest rate (meaning they’re paying more in interest every month than necessary, based on market rate). Obtaining a lower interest rate by refinancing is always the end game for a rate-and-term deal, as long as you aren’t getting hammered by closing costs and fees tacked onto your new mortgage.  

When you close on a new rate-and-term loan, your monthly mortgage payment should be significantly lower. Better yet, you’ll have the same amount of equity in your home and owe the same amount on your principal.

On the other hand, a cash-out refinance draws away equity in the home and puts it in your pocket. Are you smart enough to make good decisions with that money?

As an example, let’s say you owe $150,000 on your mortgage, your house is worth $210,000 and you want $25,000 on a cash-out refinance. You can walk away at closing with the idea of using the money for home improvements and other expenses, but the new principal balance on your mortgage is back to $175,000. You’ve not only taken away some equity, but it’s possible your loan terms (including the interest rate) have also changed … and not necessarily for the better.

Losing Equity in a Refinance

You don’t need an expert to tell you this, but the folks at The Nest will remind you anyway — losing the equity in your home is generally not a good thing. It can be a cushion or a buffer in harder financial times and provide peace of mind as the economy ebbs and flows.

However, there is one way that a cash-out refinance can actually raise the equity in your home. If you take the cash and use it to make repairs and noted improvements to your home, chances are you that you can raise the market value substantially and end up breaking even on the overall deal or even making money. Then, if you want to sell your home,  you can take that money and potentially use it as a down payment for a new home.

Other Thoughts on Refinancing to Tap Equity

Mortgage refinancing can be a bit of a slippery slope unless it’s done under the right terms and for the right reasons.

Many homeowners use a cash-out refinance to consolidate high-interest debt, and that’s typically a very smart idea. What you need to remember is that the cash is a Band-Aid to relieve you from debt. In a best-case scenario, you must resist the temptation to put yourself back in the same financial hole later on. If you do, you’ll compound your loss — in equity, in the additional years you’ll be paying your mortgage, and in the endless cycle of debt you’ll find yourself stuck in.

Above all, only you can make refinancing a solid financial move. Use it to reduce your mortgage payment, or shorten the term of your loan, and in turn build equity more quickly. If you need to take cash out, use it only as a means to bring debt under control once and for all. But always take a close and careful look at your financial situation before making a refinance your final solution. Phone a friend, call a lender, and get advice on the best way to proceed and make sure you’ve retained some equity in your home.

References

Author: Bryan Dornan

Bryan Dornan is a financial journalist and currently serves as Chief Editor of Cash Out Refi Tips.com. Bryan has worked in the mortgage industry for over 20 years and has a wealth of experience in providing mortgage clients with the highest level of service in the industry. He also writes for RealtyTimes, Patch, Buzzfeed, Medium and other national publications. Find him on Twitter, Muckrack, Linkedin and ActiveRain.

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