Can I refinance my bad credit mortgage and leave my home equity line of credit alone?

By Gina Pogol
Mortgage Credit Problems Columnist

Dear Gina, I have worked hard to fix my bad credit, and my credit score is now above 620. I want to refinance a bad credit mortgage that has an 8.75 percent interest rate, probably moving into a new FHA home loan. I got an adjustable home equity line of credit last year that's at 3.25 percent right now, which I'd like to keep. Can I refinance my first mortgage without paying off my second mortgage? - Jenny, Oklahoma City, Okla.

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Dear Jenny,

Refinancing out of a bad credit mortgage to a lower rate and payment is your reward for taking care of your credit problems. And you should be able to keep your home equity line -- but there are rules.

1. Your combined loan-to-value (CLTV) must fall within the guidelines of the refinance lender.

As an example, if you have a first mortgage at 80 percent of your home's value and a second at 15 percent, your new lender must be willing to refinance with a CLTV of at least 95 percent.

In the case of FHA refinancing, the FHA eliminated the unlimited CLTV refinance in 2010. Here are CLTV current limits, by type of FHA refinance:

Rate and term (no cash out) refinances

97.75 percent

For borrowers in negative equity positions (through 2012 only)

115 percent

FHA-to-FHA Streamline Refinances, with or without appraisals

125 percent

Cash-out refinances

85 percent

2. The holder of your second mortgage must be willing to subordinate it to the first mortgage.

The bad credit mortgage lender you want to replace is in what is called first position, and your home equity lender is in second position. In case of default, lenders in first position gets repaid first (from the proceeds of a short sale or foreclosure sale), and the lender in second position gets paid only if there's anything left.

When you refinance only the bad credit first mortgage, the second mortgage would automatically move into first position, and the refinance mortgage would end up in second position. That won't work; the new lender will not grant you a mortgage unless the second, home equity lender agrees to subordinate, or put its loan in second position behind the new loan.

Your home equity lender may have some additional requirements, such as these four:

  1. You must be current on your loan payments.
  2. Your refinance can't increase your monthly payment beyond certain limits.
  3. You can't take cash out or consolidate debt with your new first mortgage.
  4. You may have to pay some administrative fees.

You may be able to get payment or cash-out exceptions if your financial position is strengthened -- if, for example, debt consolidation drops your debt-to-income ratios -- and/or your application is particularly strong -- if, for example, you have excellent credit and income.

If your home equity lender won't subordinate

Your second mortgage holder should want to subordinate if you're in good standing and the new first mortgage puts you in a stronger financial position.

If it doesn't, you have the option of refinancing your second mortgage as well with a new lender. Get the subordination policy of the new second mortgage lender in writing so you know you can subordinate it to a new first mortgage. In fact, any time you take out a second mortgage, it's a good idea to get the lender's subordination policy before agreeing to the mortgage terms.

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