You built up some equity in your home and you want to tap into it. Before you do so, though, you want to refinance your first mortgage. Rates dropped since you purchased your home and you want to save some money. Can you do both? Yes, you can, but the order you do them in will have a direct impact on how much you save. Generally, before you open a HELOC, you should refinance your first mortgage, if that is your intent. Waiting to do it in reverse order could negatively affect the savings you reap by refinancing your first mortgage.
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What’s the Difference?
There is a major difference in the eyes of the lender if you take equity out of your home before you do a rate/term refinance. Technically, if you take money out of the equity of your home, you are taking cash out. This means if you take the HELOC out first, you make it a cash-out refinance. Even though the refinance of your first mortgage is just to lower the rate. Because you altered the amount of equity you have in the home, you made it a cash out loan. To the lender, this means a pricing adjustment. To you, this means a higher interest rate.
Refinance your 1st Mortgage First
The best way to go about in a situation like this is to refinance your 1st mortgage first. Yes, this may slow the process down, delaying the access to the equity funds, but it is the most affordable way. When you refinance your first mortgage, it is literally a rate/term refinance. You will be able to secure the lowest interest rates and best terms this way. Because the equity you have in the home increased since you purchased the home, you have more leverage this time around. A lower LTV means a lower risk to the lender. They can then provide you with a lower interest rate.
Open a HELOC Last
Once the refinance on your first mortgage is complete, you can apply for a HELOC. Because the terms of a HELOC will likely be the same whether you refinance your first loan or not, it may not have much impact when you open the HELOC. One benefit you may realize by refinancing your first mortgage beforehand is a lower debt ratio. If you were able to lower your payment, it impacts your monthly debt ratio less. This leaves you more room for approval on your HELOC.
Things to Think About With the HELOC
There are a few things you should keep in mind when you take open a HELOC. Because it is a cash-out refinance and it holds your home as collateral, you have to be careful. HELOCs work much like a credit card. You get a specific credit line to use. Once you use it up, the credit line is gone. However, when you pay it back, you are free to use it again. This goes on and on during the draw period. For most HELOCs, this means the first 10 years of the loan.
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If you use the HELOC for debt consolidation, you need to be careful that you don’t rack up the same debt all over again. This can happen if you pay off your credit cards with the HELOC funds and then have available credit again. People who are addicted to charging things they cannot afford will continue to charge those credit cards up again. This time around, though, you will have used up the equity in your home and still be paying on it. Now you have double the debt, putting yourself in a bad position.
If you use the HELOC to fix up your home or for other large expenses, though, it could be a great way to make it more affordable. HELOCs often have low interest rates and affordable closing costs. They give you access to the funds in your home without too much hassle.
The Problem with Having a HELOC for a Refinance
A HELOC can pose a major problem for you if you need to refinance. The HELOC is in 2nd lien position when you first take it out. However, when you try to refinance your first mortgage, the home equity loan takes the first position when the original 1st mortgage is paid off. Now, the 1st mortgage lender who refinances your loan is in 2nd position. This is not where they want to be, so they require your HELOC lender to subordinate their loan. More often than not, lenders agree to subordinate because they already held 2nd position. On the off chance that a lender became unwilling to subordinate, though, you could find yourself unable to refinance your first mortgage if you were to open a HELOC first.
The best way to go about the process is to close both loans at the same time. If you can use the same lender, you can kill two birds with one stone. This way you refinance your first mortgage, making it more affordable and then take the cash out of the equity of your home with the HELOC. You can minimize the closing costs and even the paperwork involved in the transaction if you do them together.
If you are unable to find a lender willing to do both at the same time, though, you are better off refinancing your 1st mortgage before you open a HELOC. This way you secure the best terms and don’t have to go through the hassle of subordinating the second mortgage.
Before you make a decision, shop around with various lenders. Make sure to look at the large, traditional banks as well as local, private lenders. They each have different programs available which can help you decide what is right for you. Make sure you look at the APR of each loan as well as compare the closing costs to make sure it makes sense to refinance both loans so close together.