Many aspiring homeowners utilize 80/20 loans to avoid paying PMI (Private Mortgage Insurance). PMI is required when a mortgage equates to greater than 80% of the home value. So what is an 80/20 loan? Well it allows home buyers to take out two loans: one for the 20% down payment to avoid PMI and one for the 80% principal mortgage amount. Essentially, the loan is 100% financed and PMI is averted.

With 80/20 loans, the 20% loan is usually at a higher interest rate than the 80% mortgage.  Due to this rate increase, borrowers often choose to refinance after a period of time to lower their existing rate and secure a lower monthly payment.

If interest rates are currently lower than your mortgage’s interest rate, you may benefit from refinancing. Unfortunately, refinancing an 80/20 loan is not as easy as it may seem. Here is what you need to know before you take this important step:

Your Equity

Your equity or your loan-to-value ratio (LTV ratio) is the number your lender will use to determine your eligibility for refinancing. Your loan-to-value ratio is the amount of your loan principal divided by your current home value. Even if you have been paying down your mortgage, if your home value has decreased due to a slumping market, your equity will be lower than you may desire. A high percentage of principal left in relation to the value of the house will virtually eliminate your chance of refinance. However, if you have built some equity in the house and your LTV ratio is low, a lender will see you as a more favorable candidate for refinancing.

Loan to Value Ratio = (Loan Amount / Appraised Value of Home) x 100

Example: You owe $150,000 on your property and the appraised value is $175,000

Your Loan to Value Ratio = ($150,000 / $175,000) x 100 = 86.7%

To calculate your percentage faster, use this mortgage loan-to-value calculator.

If your LTV ratio is higher than 80%, your lender will require you to pay private mortgage insurance. To make the right decision, you must weigh the benefit of the lower interest rate against the new payments with PMI included. Remember also that both interest and private mortgage insurance is tax deductible.

If your home value is less than your mortgage amount, which would send your LTV ratio over 100%, most lenders will not refinance your loan. To find out if you can refinance your loan, fill out this simple form.

Terms of the Loan

In most cases, the 20% loan is borrowed at a high interest rate. As a result, refinancing this loan may cost you extra expenses and upfront fees. Review the terms of this loan and determine whether it makes financial sense for you to refinance. Look for any prepayment penalties as well.

Which Loan to Choose

Refinancing an 80/20 loan brings many options to the table. Borrowers can combine the loan into one mortgage product or refinance each portion separately. Furthermore, they have the option to choose whether to apply for an ARM or a fixed rate mortgage.

Your decision on which mortgage loan to choose will depend on your personal situation and the current state of the market. For those borrowers who have a high LTV ratio, FHA loans generally accept higher percentages than conventional refinances.

Assess whether refinancing is the best option for you at the current time. Ideally, you will want to decrease your monthly payment with a lower interest rate, but with private mortgage insurance as a possibility and lender fees, refinancing may not be the best option.

Speak to a mortgage professional to evaluate your current financial condition and the exact terms of your current loans. Your equity, potential fees and payments as well as the market will be assessed to determine your ideal choice when it comes to refinancing.