Can I pay off my home equity loan when I refinance?

By Gina Pogol
Mortgage Credit Problems Columnist

Dear Gina, I have a bad credit mortgage and a home equity loan with a high interest rate. But my credit score has improved to more than 600 and I was told I can refinance with FHA. Can I pay off both loans with a refinance mortgage? - Jim, West Plains, Mo.

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Dear Jim,

Congratulations on cleaning up your bad credit. Refinancing out of your two mortgages is a great idea if you have enough equity.

Refinancing with an FHA loan

Here is what you need to know about refinancing with FHA:

Credit score. Though the FHA only requires you to have a 580 credit score, 80 percent of FHA lenders require a score of 600, 620, or 640. When you shop for a bad credit refinance, ask the loan agent what the lender's lower credit score limit is so you don't waste your time. The better your income, job stability and mortgage payment history, the better your odds of being approved.

Home equity. You only need 3.5 percent home equity when you refinance your bad credit mortgage with FHA. So if your house is worth $200,000, you can refinance both of your loans if their total doesn't exceed $193,000.

If your refinance is considered cash-out (see below) you can refinance up to 95 percent of the property value as long as you meet certain requirements. Otherwise you are limited to 85 percent.

Second mortgages. When combining a first and second mortgage, there are a few additional rules:

  • Your second mortgage must be at least 12 months old to refinance with an FHA mortgage. This is referred to as "seasoning." However, this seasoning requirement can be waived as long as the proceeds were used to improve your property and you can prove that the property improvements were completed.
  • If your home equity loan is a line of credit (HELOC), you cannot have drawn more than $1,000 in the last 12 months, or your refinance is considered a cash-out refi (with a maximum loan-to-value of 85 percent rather than 96.5 percent). The HELOC rule can also be waived as long as the proceeds drawn in the last 12 months were used to improve your property and you can prove that they were.

If you don't have enough home equity

What if you don't have enough home equity to pay off both loans? You might keep your second mortgage and just refinance the first with an FHA loan. FHA allows you to have a higher loan-to-value as long as the home equity lender is willing to subordinate its loan to the new FHA loan. That means the FHA mortgage will be in first position (first to get paid off from a sale if you end up in foreclosure) and the home equity lender will stay in second position.

If you do this, I recommend that you use the monthly savings from refinancing your first mortgage to pay off your second mortgage faster. If your second mortgage is a home equity line, there is no reason that you shouldn't keep the HELOC available for emergencies; just don't use it for silly things like boats and vacations.

Another option, if you can swing it, is to do a cash-in refinance until the combined loan-to-value meets FHA limits. You basically pay down your second mortgage to the point where you can wrap both loans into the new FHA refinance.

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