While you’re paying down your mortgage, you may find yourself in a situation where you are considering accessing equity or looking for a lower mortgage rate; to do either, you will need to refinance your mortgage.
There are three different ways you can refinance: you can break your current mortgage term early, take out a home equity line of credit (HELOC) behind your existing mortgage or get a blended mortgage.
Before sitting down with your lender to sign the paperwork for any refinance, you should first understand the differences between your three options.
|Break Mortgage||HELOC||Blended Mortgage|
|Credit Limit||80% of home value||80% of home value1||80% of home value|
|Can it Be Used to Access Equity?||Yes||Yes||Yes|
|Access to Equity||Lump sum||As needed||Lump sum|
|Can it Be Used to Lower Rate?||Yes||No||Yes2|
|Rate Type Available||Variable/Fixed||Variable||Variable/Fixed|
|Mortgage Rates||Today’s lowest rate||Today’s lowest HELOC rate||Blended rate of your current rate + today’s lowest rate|
|Payment Type||Traditional (Interest + Principal)||Interest only||Traditional (Interest + Principal)|
Breaking your mortgage
You could break your mortgage if you wanted to access a lump sum of equity and/or obtain a lower rate in a new mortgage. By breaking your mortgage, you’re paying off your current mortgage and setting up a new mortgage entirely. Unfortunately, doing this will result in a prepayment penalty – and, depending on your mortgage rate and how much time is left in your mortgage term, it can add up quickly. If you had a fixed rate mortgage, your penalty would be the greater of three months’ interest or the interest rate differential (IRD). If you had a variable rate mortgage, your penalty would be three months’ interest. If the potential savings outweigh the penalty, or if the value to you in withdrawing that money is great, it might be worth paying the fee. However, there are still other options to consider.
Taking out a Home Equity Line of Credit (HELOC)
If current market rates are better or the same as what you have, and you wanted to access the equity in your home on an as-needed basis, you could take out a home equity line of credit (HELOC) instead. With a HELOC, you wouldn’t get a lump sum of cash, but could instead access up to 80%3 of the value of your home through a revolving line of credit. The one key difference with taking out a HELOC, versus breaking your mortgage or getting a blended mortgage, is that it is a separate mortgage product. Each month, you need to make an interest-only payment – on top of your regular monthly mortgage payment. Fortunately, you only need to pay interest on the amount you’ve borrowed – not on the total available credit. And perhaps the biggest bonus of taking out a HELOC is you don’t have to pay a hefty prepayment penalty in order to access your equity.
Getting a blended mortgage
Finally, there is one other way you can refinance to access your equity and/or get a lower mortgage rate, without having to pay the prepayment penalty: it’s called a blended mortgage, and it’s an under-utilized tool in mortgage financing.
A blended mortgage is when you combine the mortgage rate from an existing mortgage with the mortgage rate from a new mortgage and blend them into a new rate that is somewhere in-between the two. Because you’re essentially “keeping” your existing mortgage rate in this new blended rate, rather than breaking your mortgage term altogether, you can avoid the prepayment penalty that comes with a typical refinance. So with a blended mortgage, you wouldn’t get the absolute best mortgage rate on the market, but you also don’t need to pay any penalty upfront.
You can get a blended mortgage when you want to access equity, obtain a lower mortgage rate or both. The one thing to keep in mind is that there are two different types of blended mortgages: the “blend and extend” and the “blend to term”.
Blend and extend
Let’s say you owe $250,000 on your mortgage, and you have two years remaining on a 5-year term with a fixed rate of 4.50%. Through a refinance, you could take on a new 5-year fixed term at just 3.39%. However, to get that rate, you’d have to pay a prepayment penalty of $10,325.
To avoid that fee, you could instead blend together your existing mortgage rate with the new mortgage rate, for a new 5-year fixed term at a rate somewhere between 3.39% and 4.50%. So, not only have you “blended” the two rates, you’ve also successfully avoided having to refinance your mortgage and pay a penalty to do so. See below for example:4
If you had also decided to access some equity in this refinance, your blended rate would be even more weighted against current market rates, because your total mortgage amount, monthly payment and overall interest would’ve gone up, giving the lender more money from you in other ways.
Blend to term
With a blend to term, you’re “blending” the two rates in the same way as the blend and extend, but you don’t extend your mortgage term. Sticking with the example above, where you had two years left in your term, you would get a lower rate (in between your existing rate and what’s currently being offered for a 2-year term, but leaning closer to your existing rate) but it would only last for those two years remaining. See below for example:5
Because you’re not extending your term, your lender would lose money by slashing your rate and refinancing your mortgage without penalty. To make up the difference, a blend to term is typically only offered if you are also accessing equity, thereby increasing your mortgage amount - and the total amount you would pay your lender during the remainder of your term. If you don’t want to access equity, but you also don’t want to extend your term, your lender has the right to charge you a portion of the prepayment penalty incurred during a typical refinance.
Which lenders offer blended mortgages?
|Lender||Blend & Extend||Blend to Term|
|Available?||Fixed or Variable?||Available?||Fixed or Variable?|
References and Notes
- While your mortgage + HELOC can be up to 80% of your home’s value, the HELOC alone can only be 65% of your home’s value.
- Note that if today’s lowest rate is higher than your current rate, your new rate would actually go up – not down.
- Your mortgage + HELOC can be up to 80% of your home’s value, but the HELOC alone can only be 65% of your home’s value
- This is an example rate, not a calculated rate.
- This is an example rate, not a calculated rate.