Favorable market rates don’t mean that refinancing is right for you. Before jumping on the bandwagon, assess your circumstances and if it’s the right way forward.
Here’s what you need to evaluate before deciding to refinance your mortgage.
I | What Is Mortgage Refinance?
Refinancing your mortgage replaces your present loan with a new one. Your new loan will pay off your old balance, and you’ll continue with a new principal, interest rate, terms, etc., based on the type of mortgage you choose.
There are a few reasons why a homeowner might decide to refinance.
1. Lower Mortgage Interest Rate
Homeowners often refinance to reduce their interest rates. Mortgage loan rates fluctuate. If the present rates are lower than at the signing of the original mortgage, refinancing might make sense.
Reducing your interest rate has a cascading effect. Lower interest means lower monthly payments and less paid interest over the new loan term.
2. Change Your Loan Term
Homeowners refinance to reduce loan terms to save on interest and pay off the loan faster. Financial situations change. If you started with a 30-year loan but can now afford a higher interest rate, you might refinance with a ten or 15-year mortgage for a shorter term.
The reverse can also be true. Perhaps you started with a 15-year loan but met some financial difficulties. You can extend your term and lower your monthly payments.
3. Change Loan Type
The benefits of changing your loan extend to the type of mortgage you initially received. Perhaps you started with an adjustable-rate mortgage (ARM). These mortgages typically begin with lower interest rates than fixed-rate loans, with increases added over time.
You can trade in the uncertainty of when your ARM might increase by switching to a fixed-rate mortgage and locking in a low, unchanging rate.
4. Take Advantage of Your Home’s Equity
Your home’s equity offers several financial opportunities.
If you have enough equity in your home, you can refinance and convert your FHA loan into a conventional loan, eliminating your private mortgage insurance payments.
Cash-out refinance is another option homeowners use to turn their home’s equity into cash. If your home’s value reaches the qualifying threshold, you can borrow more than you owe and keep the cash difference.
Using money from your home allows you to borrow at a much lower interest rate than most other loans. You can use this money for home improvements, paying off debt, or other expenses.
The cash-out option, however, has tax implications.
5. Changing Loan Details
Refinancing a home loan after a divorce is a common practice. You can remove your ex-spouse’s name from the mortgage during the process. Likewise, you can refinance to add someone to the mortgage.
You can’t add someone to your home loan without refinancing and going through the closing process again. Although mortgage lenders can remove a co-borrower with a loan assumption or modification, they’re not required to grant either. Refinancing the loan in your name alone is your best bet.
Removing a borrower might affect your loan rate and conditions, especially if your income, credit score, and history aren’t up to par. Your current mortgage lender will reassess your creditworthiness and may approve or decline your application.
Adding a co-signer will have the opposite effect, as your combined records and credit scores could qualify you for better rates.
Whatever your reasons for refinancing, make sure it’s worth the time and associated costs. Assess the impact it will have on your finances by referencing the points below and your unique life situation.
II | Things to Consider Before Refinancing Your Mortgage
Question: Is it worth it right now?
1. Refinancing might not save you money.
The goal of monthly savings lures a lot of homeowners into refinancing. But there are no guarantees of potential savings. So, before you start daydreaming about what you want to do with your extra cash or start the refinance process, check if it’s worth your time.
Current Mortgage Rates
Mortgage rates sometimes rise faster than even economists are able to predict. Locking in low rates while available is a big draw for homeowners looking to refinance.
Compare the current market rates with what you’re paying now. Use an online mortgage refinance calculator to help you crunch the numbers. These free tools offer estimates for your new payment and monthly and lifetime savings.
With this information, estimate your break-even point.
Break-Even Point
Your break-even point is where you recover the refinancing costs from your monthly savings. If you spend $3000 on refinancing and save $150 a month on your new loan, you’ll recoup your costs in 20 months. If you plan on moving out or selling your house within two years of refinancing, doing so makes no financial sense.
You won’t be there long enough to get your money back.
The longer you stay in your home, the more you’ll benefit from the actual savings you want once you break even on the fees.
Weigh your options carefully, or you may lose rather than save.
2. What’s your home’s current equity?
Equity is the difference between what a homeowner owes and what the home is worth. In other words, if you own a home worth $150,000 and owe $130,000, your equity or ownership share is $20,000.
Each time you make a payment on your mortgage loan, you build equity.
Negative equity means a borrower owes more money than the home’s value. If your home’s value is $75,000 instead of $150,000 as it was at the time of purchase, and your current loan balance is $130,000, your home has negative equity of -$55,000.
Refinancing with conventional lenders may not be possible if your property has little or negative equity.
Speak with your lender about your mortgage statement. This statement outlines all the payments on your principal balance and the outstanding monies owed. Expert consultation is the faster way to learn if you stand to win or lose when refinancing.
Question: Are you financially ready for the refinancing process?
3. What’s your credit score?
Credit scores play an essential role in determining how expensive loans are. While the current average mortgage rates give you an at-a-glance idea of if you can save, your qualifying refinancing rate hinges on your credit history.
The healthier your credit, the more likely you will qualify for the lowest mortgage interest rates.
Do your credit check before applying for a loan or mortgage. Review your credit score by looking up your credit report online. Apply with multiple scoring agencies, as each company uses a different grading scheme. Report any errors and outdated information to the credit bureaus.
Lenders set their credit requirements. Most conventional lenders prefer borrowers with credit scores of 760 or higher.
Try to improve your credit score before refinancing. Your current score might be low because you haven’t paid off any debts. To increase it, pay your bills in full and on time, cut down on your expenses, and work toward paying off old debts.
Lenders require a hard credit check when reviewing your application, which might temporarily lower your credit score.
4. Your debt-to-income ratio (DTI) is too high.
Your debt-to-income ratio measure how much of your gross income goes towards repaying debt. When lenders evaluate your mortgage loan application, they examine your DTI and credit history.
Any debt you acquired after your present mortgage could make refinancing difficult. Lenders have raised the bar for credit approvals and implemented stricter DTI requirements. Having a DTI ratio of 35% or less increases your chances of approval.
Question: Are you prepared for the costs of refinancing?
5. Do you have enough for the closing cost?
Before finalizing your refinance, you’ll have to pay closing costs. The amount depends on where you live, as refinancing costs vary by state.
Some of the most common fees include:
- Application fee: Your lender might require an application fee when you apply for a refinance. It’s an upfront, nonrefundable payment that doesn’t affect your approval or denial.
- Loan processing fee: Your lender may charge for processing your application. Processing fees cover tasks like your credit check and income verification.
- Title search and insurance fees: If you switch lenders, they’ll charge for searching public records to confirm ownership and if there are any liens or claims on your property. You may have to pay for title insurance. This insurance protects you and the lender against another person claiming an ownership interest, fraud, incorrect records, and other items mentioned in the policy.
- Appraisal fee: Lenders require an appraisal before refinancing. The assessment will confirm the current value of your home and if you’re in negative equity or not. Lenders want to make sure they’re not giving you a loan that values more than your home is worth.
- Inspection fee: Some states require a home inspection as part of the refinance application process. A home inspection confirms that your home is in good structural condition and free of damages and pests.
- Attorney fee: Some states require the use of an attorney to review all of your documents before closing.
You have two options for paying closing costs. You can either pay it upfront or ask your lender to include it in your loan. Including the closing fees into your loan means you’ll pay interest on them for the duration of your new loan.
Closing costs may range from 2 to 6 percent of your total loan.
Question: Do you understand the fine print and risks of refinancing your mortgage?
6. Refinancing resets the clock on your mortgage.
Refinancing restarts the clock on your mortgage. Based on your repayment schedule, you’ll be repaying the bulk of the interest at the start of the loan. The interest can take years to repay before you start clearing the principal balance.
If you plan to stay in your home for another decade, this is not a negative factor. The longer you stay in your home, the more the reset will benefit you in the long run.
7. Refinancing has tax implications.
Mortgage interest rate deductions help to lower your federal income tax bill. However, your tax deduction will decrease if you refinance and pay less interest. The reduction depends on the difference between your previous and present interest rates.
The amount a homeowner loses is not usually enough reason not to refinance. Speak with a tax advisor about the impact of refinancing on your taxes. The results vary by state.
8. Refinancing has pitfalls.
Refinancing isn’t a stop-gap for covering poor spending habits. You’re building equity if you take the cash-out refinance route and invest that money into renovating or expanding your home. But, if you’re taking out a loan on your house to repay credit card debt, this may lead to more problems down the line.
You’re jeopardizing your home if you habitually spend more than you earn. Your lender will claim your home as collateral if you default on your mortgage payments, leaving you homeless and in debt. Your credit score will take a beating in the process.
Conclusion
Refinancing is not for everyone. Before you start the process, take stock of your financial situation.
- Is it worth it right now? Refinancing won’t save you money unless current mortgage rates are significantly lower than what you’re already paying. Rates and the value of your home dictate your potential savings. Factor in your break-even point and how long it’ll take to recoup the expense of refinancing.
- Are you financially ready for the refinancing process? Check your credit score and DTI. A score of 760 and a debt-to-income ratio of 35% or less will make it easier to get favorable rates.
- Are you prepared for the costs of refinancing? Refinancing incurs additional loan fees. These will vary by state and mortgage loan type. Instead of rolling the closing costs into your loan, paying upfront will save you money on interest payments.
- Do you understand the fine print and risks of refinancing your mortgage? Resetting the clock on your mortgage also resets the timeline of your interest payments. Prepare for a decrease in your tax deduction if you’re paying less interest. Refinancing puts your home on the line. Only choose it after carefully considering what you plan on doing with the money if you cash out.
