Should You Refinance Your Mortgage?
When mortgage rates are low, it not only makes purchasing a home very attractive but also refinancing your mortgage to a lower rate.
If you purchased your home at an interest rate of 5.5%, and the current rate is 3.5%, it is almost too good of a chance to pass up saving that much money over the life of your mortgage.
Lower rates not only mean saving money, but it also means being able to pay down your principal faster!
Paying down your principal is great because it means you are less in debt and also gives you more equity or buying power.
Should You Refinance?
- Refinancing means taking out a new loan to replace your original mortgage with different terms.
- Homeowners usually refinance their mortgages for better rates, lower monthly payments, a shorter term, a cash-out, or fixed-rate mortgage.
- Using an online calculator can help you decide if it's worth refinancing.
- Some cons to refinancing can include high closing costs, stressful underwriting process, a longer-term, and paying more interest in the long run.
- Qualifying for refinancing is nearly identical to applying and qualifying for your original mortgage.
- Knowing why you want to refinance and crunching the numbers can help you decide if refinancing is right for you.
What is Refinancing?
Refinancing a mortgage is when you take out a new loan to pay off your original mortgage loan, and the new loan then replaces the existing one.
The most common reasons for refinancing your home is to receive a better interest term and rate.
Some homeowners refinance to pay off their original mortgage loan, to take out a sum from their equity, and to replace their monthly mortgage payment with a longer repayment term.
The interest rate ultimately decides whether you should refinance.
If your new interest rate on your new mortgage is lower than the interest rate on your current mortgage, and the total savings outweighs the cost to refinance, then refinancing may be very enticing to homeowners who want to save money.
Understanding the Refinance Process is Key
But refinancing can also throw you a curveball.
If you don’t know why and when to refinance, or even how to do it, instead of saving money you may just end up losing funds.
So how do you know why, when, and how to refinance?
We’ll take you through the refinancing process so you’re actually profiting from taking out a new loan.
Why Should You Refinance?
Below are popular reasons why people refinance their mortgages.
Lowering Your Rate
This is refinancing 101.
If you have the means and you find the right deal, lowering your rate could mean tons in savings over the next 15, 20, or 30 years.
Paying Off Your Loan Faster
You might be able to pay off your mortgage in a shorter amount of time by changing the number of years of amortization.
This means you can shorten your original mortgage of 30 years to 15 years.
As a result, you’ll save a significant amount of money in interest payments over the life of your loan.
This new length—dropping down to 15 years-- offers you greater interest savings and, best of all, can also assist you in building equity faster than if you remained with your 30-year loan.
On the flip side, if you refinance with another 30-year term to reduce your monthly mortgage payments, you’ll end up taking even longer to pay off your mortgage and paying more interest over the life of the mortgage.
But what if your finances change, and not for the better?
Don’t fret. You have the option to revert to your original 30-year loan.
Changing Your Rate Type
Homeowners who have a mortgage with a riskier type of loans such as an adjustable-rate or balloon loan can refinance to get a fixed-rate mortgage.
Your new fixed-rate might end up being higher but know that you’ll be secured when loan rates increase.
Moving to a loan with a fixed rate can help you bypass market fluctuations.
As a reminder during the 2008 housing crisis, thousands of Americans defaulted on their loans when rates skyrocketed and lost their homes to foreclosure.
So, it's a good thing to try and get out of your adjustable-rate mortgage.
A cashout uses the equity that you have accumulated in your property to borrow money at a decreased price.
With a cashout refinance, you’re able to refinance for an amount higher than your current principal balance and take the extra funds as cash.
So if your property is worth, say, $300,000 and there’s $100,000 left on your current mortgage, this means you have home equity in your home worth $200,000.
Equity is the difference between a home’s market value and the debt owed on the property.
The most important reason why homeowners cashout is the fact that they can use the money to make major improvements in their home that will end up increasing the home’s value.
But there are also other reasons.
Many who have children use the cash to pay for school tuition, or a down payment on a house, while others use it to pay off medical costs.
A popular reason why homeowners refinance is to consolidate other debts into a monthly payment plan that is easier for you to swallow.
This occurs when a portion of your home equity is turned into a cash-out and the homeowner can use the money to pay off debts like credit card debts, student loans, or a second mortgage.
Debt refinancing is very similar to a cash-out.
If you have a lot of debt, such as credit card debt, you may know that the average interest rate on these cards features a high median rate of about 13.66%.
In contrast, the median mortgage interest rate is 3.85%.
In the long term, you’ll be saving a lot of money from the lower interest rate when you roll your debt into your mortgage.
Using a Calculator to Help Decide If You Should Refinance
We've established that basically when the interest rate is lower than the interest rate on your current mortgage, it might be the time to consider refinancing.
Also, if your cumulative savings amount outweighs the costs to refinance.
But if you base your refinancing on falling mortgage rates, you should be very cautious as mortgage refinance interest rates change daily and are never constant.
How much will you save? And how much will it really cost?
The best way to do this is by using an online mortgage refinance calculator.
By plugging in your new interest rate and your new loan amount, the tool will calculate your monthly savings and your new payment that takes into consideration the estimated costs of the refinance.
Although the calculator can only give you an estimate, it also can reveal to you what you should expect.
What Are Some Reasons Not to Refinance?
Refinancing is not always a walk in the park.
If you lengthen your loan term, you may have to pay more interest.
If you use some of your equity, you will receive a higher loan amount on your refinancing loan, which, in turn, can increase your monthly loan payments.
Going Through Underwriting Again
Remember when you were approved for a mortgage on your dream condo?
It was a stressful endeavor, and not something homeowners want to repeat.
Well, if you want to refinance, it’s going to be the same process again submitting income documentation, proof of assets, and your debt.
Sure, the market looks great, but there are two popular reasons why you shouldn’t refinance.
The Return of Bad Credit
The process of refinancing can actually hurt your credit score, which we'll delve into deeper in a bit.
If your score is already somewhat on precarious standing, you might want ti sit this one out for a while until your credit is impeccable.
A Longer Break-Even Point
One of the reasons to avoid refinancing is it takes too long for you to get back the closing costs on a new loan.
This is known as your break-even period, the number of months to reach the point when you start saving, thereby counterbalancing the costs of refinancing.
You have to think ahead when it comes to refinancing.
Remember that you need money once your new loan is approved. The costs of a refinance will include a lot of fees.
There’s the closing cost, the lawyer’s fee, a loan origination fee, escrow charges (taxes) a mortgage insurance fee, and the credit report that the lender purchased.
In addition, you also have to pay the fees below:
- Application Fees ($75-$100)
- Appraisal ($300-$700)
- Survey Cost ($150-$400)
- Title costs, which include a title search and insurance ($700-$900)
- Home inspection ($175-$350)
Closing Costs Can Vary Dramatically
The total fees you may have to pay will be around $5,000, however, in some cases, closing costs can rack up to $10,000-$15,000.
Factors such as the area around your property, the property itself, as well as your credit score, will determine how much it costs when you close.
In places like New York City, where jumbo mortgages are the norm, your closing costs will likely be on the higher end.
For closing, you need to come up with the money all at once. It might mean you aren't in a position to refinance.
However, you might be able to roll all the costs into the new mortgage itself.
While you'll need less cash at closing, keep in mind that your monthly loan payments will increase and so too will your interest over the life of the loan.
If these become greater in size, it may not be cost-effective to refinance.
Of course, many refinance to lower their interest rates and monthly loan payments.
However, the process includes extending the loan’s term.
If you do this, you’ll end up having to pay back more in interest over the entire period of the loan.
You Need the Tax Deductions
Interest on your monthly mortgage payments is tax-deductible on your federal income tax, up to $10,000 a year.
If you want to take full advantage of this tax break, reducing your monthly interest will also decrease what you can deduct.
When is a Good Time to Refinance Your Home?
It may seem like the right time to refinance is when mortgage rates have dropped, however, there are other instances when refinancing makes sense.
Rates are Low
It’s often the case that homeowners who want to refinance their house do so when they notice mortgage rates falling below their current loan rate.
If rates dip temporarily, it's not a good time to act as they can go back up before you get a commitment for refinancing.
You should be looking for a time when mortgage rates are low due to some economic factors.
The Fed will normally cut rates when they feel that the buying power of Americans is falling and fewer people are able to buy or planning to buy.
Your Credit Score Has Improved a Lot
Your mortgage refinance interest rate is mostly based on your credit score, as well as how much equity you have in your home.
Your credit score is very important.
If your credit score was just fair (around 620) when you got your original mortgage, chances are you didn't qualify for the best rates.
If now you have an outstanding credit score (around 800) and good payment history on your loan, you will qualify for a better interest rate when you refinance.
If you want to know when to refinance, be aware of two things: your potential savings when you refinance and how refinancing could potentially hurt your credit score.
Your Income Increased or You Reduced Your Debt
If you've gotten a pay raise, have more assets, or managed to pay down your monthly debt you can refinance to a more favorable term.
By showing that you can increase your monthly payment, you can ask for a shorter term and pay off your mortgage sooner.
Changing it up to a shorter-term will also mean less interest paid over the life of the loan.
Just make sure that the added closing costs don't offset your savings or set you back too far.
Qualifying For Refinancing
Mortgage lenders consider the following factors when trying to secure a new loan.
Your FICO Score
Your credit should be in good standing, and not showing a lot of new debt or inquiries.
Those homeowners who have a good-to-great credit history are usually easily approved for a refinance.
And if your credit has significantly improved since you took on your mortgage, you may just find yourself with more agreeable terms.
Good to Exceptional scores range from 670-850.
Your Income and Employment History
Creditors want to see that you have a stable livelihood and income.
You shouldn't have any issues if you can prove a steady number of years at your current job, with the same or an increase in salary.
Equity in Your Home
Another consideration for underwriting will be how much equity you currently have in your home.
This can be measured by how much of the principal you've paid off along with the downpayment you initially put down to purchase the home.
Your equity is an asset.
Your Home's Current Value
As long as the current market value is the same or higher you should be in a good position.
You won't be able to refinance if your mortgage is actually higher than the value of the home.
Usually, a full appraisal is not required although sometimes the lender may suggest doing this.
Your Other Debt Obligations
Once again, your debt-to-income ratio factors in. This is important because your income simply isn't your net income.
You need to first debit your monthly debt obligations to come up with the net income.
Sometimes, when you have balances on your credit cards, the lender might ask you pay them all down to help your chances.
What Might Disqualify You From Refinancing
There are some factors that may not make you eligible for refinancing your mortgage.
Unsteady Job History
When you apply for a new loan, lenders will almost always want to know how long you’ve been in your position at your job.
They are reluctant to give you a lend unless you’ve had at least two years of employment in a row in the same position at your job.
They will take into consideration if it happens to be that you have a new job, but only if it’s the same profession as your former job.
And while you may have a ton of assets or have a high salary, unless you can prove to the underwriter that you have steady work, the underwriter will still, in most cases, deny you a new loan.
Unfortunately, this does mean that freelancers could have a very difficult time qualifying for a refinance.
Lack of Funds
Loan servicers also look if you have enough assets to live comfortably while paying your monthly mortgage loan.
Typically, they want to see your bank statements for the last two months that reveal to them that you can actually afford to take out a new loan.
If you don’t, it’s likely that you’ll be denied.
Higher Debt-to-Income Ratio
Having more debt is very similar to lacking the funds or making a smaller income.
The debt-to-income ratio is one of the most important factors that the lender will look at.
So, even if you now have more debt, if your income increased even more than your debt, it will offset the ratio.
Your Credit Score Dropped
If your credit score dropped to lower levels, it will definitely jeopardize your ability to qualify for refinancing.
For example, if your credit score was originally 720 and is now 650, it could raise a red flag with the underwriter.
However, if the drop is incremental you shouldn't worry as long as it's within range and falls within fair to good.
How to Decide If Refinancing is Right For You
Homeowners should refinance based on their personal needs and not because of low-interest rates.
You need to determine the length in which you can stay at your home.
If you’re having a baby, you may have outgrown your home and are now looking to move to the suburbs rather than your two-bedroom apartment in the city.
At this time, you should never refinance as you will not be staying at your home long enough for the break-even point.
In short, if you refinance and then move, you’ll lose money in a refinance.
When to refinance again?
When you have at least 20% equity — the difference between its market value and what you owe — in your home.
Be sure to ascertain property values in your neighborhood to see how much your home may be appraised or ask a real estate broker to do this.
As mentioned, refinancing is not unlike obtaining a mortgage.
You have to compare interest rates to many mortgage lenders to find the best one suitable for you and then you have to analyze your best offer with the terms of your existing loan.
You might be happy with your mortgage lender and it may be be more convenient to just try to refinance with them.
But you should still do your homework on the lender.
You are not guaranteed the best rate or closing costs, so it's important to shop around rather than going with what's easiest.
How to Refinance
Here’s how to refinance a loan
First, be clear to yourself about why you want to refinance. Crunch the numbers and use an online calculator.
Next, shop around for the best refinance lender rate.
Get Your Documents Ready
Getting approved for refinancing requires giving your lender the necessary paperwork to ensure you can qualify.
The docs you need are similar to the paperwork you need for a single-family home.
Here’s what you should put together:
- One or two month pay stubs
- 2 years of W-2s
- Federal tax returns
- Two months of bank statements
- Copy of your insurance policy
- A recent mortgage statement
- A list of all outstanding debts such as car or student loans.
Apply for a Refinance with 3 to 5 Lenders
It’s best to submit all applications within a very short period to lessen the inquiries on your credit score.
But note that at one point here your credit score will go down no matter what.
First, choose a lender with the best rate
Next, lock in the interest rate.
Locking means that the interest rate can’t be changed for a specific period. You and your mortgage lender will attempt to close the loan before the lock is supposed to end.
Lastly, close on the loan.
This is where you need to hand over a lump sum of the money needed as we talked about.
Refinancing closing is similar to closing on a home mortgage.
But always remember that taking out your initial mortgage loan to buy your condo is the same as taking our a loan to refinance.
If you have good to great credit, you will receive a lower interest rate.
If you don’t, remember that you should wait for a while until your credit score goes up.
How Can Refinancing Hurt My Credit Score?
As mentioned earlier, refinancing will actually hurt your credit.
While it's not likely that your credit will be destroyed, there are a few different ways it can make a real impact on your credit score.
We've mentioned that refinancing will require a credit check.
First and foremost, any hard inquiries into your credit report will drop it a few points.
Factor in several inquiries from shopping for a refinance product and you're looking at a real negative impact.
Closing Your Original Loan
Once you do get approved for refinancing, the lender will be closing your original loan. Believe it or not, this has a negative effect on your credit.
Just like closing a credit card account affects your score, closing a loan will also cause a decrease. Remember that FICO likes it when individuals balance several accounts simultaneously.
Once you finish paying off your mortgage completely, you may also notice a drop in your score.
This is just the way the cookie crumbles.
An Increase in Debt
If you refinance for home equity, your score will also drop because it will negatively impact your debt to credit rate.
Even if it's not for a cashout if your closing costs
What Can You Do If You Don't Qualify for Refinancing?
There's no harm in continuing what you're doing if it's something you can continue to sustain for the rest of the life of the mortgage.
After all, there is no rule that you have to refinance.
However, for those who are not completely satisfied, there are a few things you can do in the meantime.
Borrow Money From Family
If lack of funds was your problem getting your mortgage refinanced, then you might turn to friends and family to borrow money the next time around.
The good thing about borrowing money from family is that there is no record on your credit report.
Just remember two things: the money needs to be in your account for some time before you reapply for refinancing, and borrowing money from family might create tension in your relationships.
Increase Your Savings
Instead of borrowing money from friends or family, you could also just save up money over time to be ready for the next time you apply for refinancing so you know you have the money to close.
Increase Your Mortgage Payments
Even if you are turned down for a refinance, you can still work towards paying down your mortgage faster.
Many lenders will accept paying off your mortgage early without penalty.
Remember that if you make larger payments every month, it will cut more into your principal.
The more you cut into the principal, the faster your pay off the interest as your debt goes down.
Reduce Your Debt
If your problem is your debt-to-income ratio, then you need to work down paying your other debt while keeping up with your mortgage payments.
Get Your House Appraised
Sometimes you just need that little extra push to get approved by a lender. That could be having your home appraised.
Perhaps you've made some renovations that could up the value of your home beyond the market value they're seeing.
You can have the lender send an independent appraiser to assess the true value of your home. You will need to foot the bill, however.
Key Takeaways from Refinancing Your Mortgage
There are a few important considerations before you rush off to refinance.
Remember that you have a choice. You don’t have to refinance with your current lender.
You should definitely shop around.
And you don’t have to apply to just one mortgage company.
Apply for many as you can but consider how many times your credit may be pulled.
Also, although closing costs and attendant fees vary, the median rate is roughly 2-5 % of the loan amount but often can be more than that.
You need to figure out how long it will take for monthly savings to recoup those costs or "break-even" before you begin on a long-winded journey to refinancing.
If the numbers work in your favor it can mean big savings for you and your family.