When interest rates are low, it might seem like a good idea to refinance your home, but is it the best thing for you to do or a money mistake? When you refinance, you need to look at more than just the monthly payment to determine whether or not it’s a good deal. You have to look at the fees and terms of your new mortgage.
Learn how to tell whether you should refinance your mortgage.
What is refinancing?
Mortgage refinancing means that you trade the old mortgage in for a new one. While it sounds simple, it’s like getting your original mortgage — you have to go through a full financial review.
Your lender will evaluate your financial situation to ensure that you can afford the mortgage. This means they will want to see your financial records, including your tax returns, pay stubs, and bank statements. The new lender will also run a hard credit check in the process of underwriting the loan.
Why refinance your mortgage?
There are a few reasons that you might consider refinancing your mortgage.
Lower your monthly payment
When you refinance, you can extend the time you will pay your mortgage and reduce the monthly amount owed. For example, if you are eight years into a 30-year mortgage and refinance for another 30-year loan, your payments are divided over 30 years rather than the 22 years you had left with your original mortgage.
Pay less interest
One of the main reasons to refinance your mortgage is to lower your monthly payments. By refinancing your loan, you could qualify for a lower interest rate than you currently have. With a lower rate, less interest will accrue, saving thousands of dollars over the length of your repayment term.
If your interest rate is lower, you may also save on the monthly mortgage payment and the interest payments on the loan. For example, if you have a $300,000 mortgage at 4.50%, you would pay $247,220 in interest over the life of the loan. If you have the same mortgage at 3.50%, you would pay $184,968 in interest over the term of your loan, which is a savings of over $62,000.
That’s a lot of money and a compelling reason to refinance if mortgage interest rates are down or your credit score has dramatically improved.
Access your home's equity
Another reason to refi is to access the equity in your home. Equity is the amount of your home’s value that isn’t financed. For example, if your home is valued at $250,000 and you owe $150,000 on your mortgage, you have $100,000 in equity ($250,000 - $150,000). You can check the property values in your area online or consult with a local real estate agent to help with a home appraisal so you can determine if this option is right for you.
You may want to cash out your home equity to pay down debt with a higher interest rate, pay for a child’s college education, or do home improvements. When you do a cash-out refinance, you will borrow more than the existing mortgage and get cash back that you can use for any reason. In this scenario, your mortgage payment may increase since you are financing more money.
Types of refinances
There are three types of home mortgage refinances that you can do: rate-and-term, cash-out, and cash-in. Each refinance option is used for a specific purpose. Which one you choose will depend on your financial goals, your situation, and what you are trying to accomplish with the refinance.
The rate-and-term refinance takes your current loan and swaps it for a new loan with a new (lower) rate and term. For example, you could take a 30-year mortgage at 4.50% and refinance into a new loan of 30 years for the lower rate of 3.00%.
You can also refinance for a shorter mortgage term, like going from a 30-year mortgage to a 15-year mortgage. Your new monthly payment may be higher since there’s a shorter amortization schedule, but these often have lower interest rates, saving you money in the long run.
The cash-out refinance takes your existing loan balance and adds to that balance a defined amount of equity that you have in the house. Your new loan is for a higher balance than the remaining balance on your old loan. For example, you may have a balance of $250,000 left on your 30-year mortgage with $50,000 of accessible equity. You can get a new loan for $300,000 and receive a check for $50,000 when you close.
A cash-in refinance is the opposite of a cash-out refinance. In this scenario, you’ll bring extra cash to pay down the mortgage. For example, if you owe $300,000 on the mortgage, you might want to pay it down by $50,000 so that the new balance is $250,000. This could help save thousands of dollars in interest for the remaining loan term.
Homeowners may also choose this option to remove expensive private mortgage insurance (PMI). It can also decrease the loan rate because you have a more favorable debt-to-income ratio.
7 signs it’s a good time to refinance
Before you refinance, you’ll want to do a little research as to whether or not it's a good time to refinance. Here are seven things to consider if you’re wondering whether you should refinance your mortgage.
1. You have a qualifying credit score
The better your credit score, the better the interest rate you will qualify for when buying a home. Many homeowners buy their first home using lending programs such as FHA loans which allow lower credit qualifications. Your credit may be better now than it was when you originally purchased the home for a variety of reasons, including paying down debt and building a payment history of on-time payments.
Use a free credit monitoring service such as Credit Sesame or Credit Karma to see how your credit report improves over time. Credit scores over 620 make you eligible for most lending programs, but you’ll see the best interest rates as your credit climbs above 700 and closes in on 800.
2. Interest rates are lower than your current mortgage
Watch interest rates to see when they drop lower than your current rates. A general rule of thumb is that you want refinance rates to be at least 1% to 2% lower than your current interest rate for the refinance to make sense.
You might not want to refinance into a lower interest rate if it’s less than a 1% difference because you have to pay closing costs like origination fees, appraisal fees, and more when you refinance. It isn’t worth refinancing if you won’t save money after considering all the costs.
3. You’ll pass the break-even point
The best mortgage lenders will give you details about when your break-even point will occur if you refinance the loan. The break-even point is the time it takes for your savings to equal the costs of refinancing. Remember that you typically can’t refinance without added fees. It may take several years to make up for these costs, and the point where you do is called the break-even point.
For example, let's look at a $200,000 mortgage that gets refinanced with $3,500 in fees. If the new loan saves you $150 per month, you can figure out the break-even point by dividing the fees by the monthly savings. In this case, divide $3,500 by $150 to get 23.33. That’s a little more than 23 months to reach the break-even point.
The farther out the break-even point is, the less reason to refinance.
4. You can afford closing costs
As we have already discussed, refinancing is not free. You’ll have closing costs associated with the new loan, such as attorney and application fees.
You'll save money if you can afford to pay these closing costs upfront without rolling them into the mortgage loan. Remember that it may be enticing when the lender says that you don’t have to come up with money out of pocket for the refinance, but that means you are adding closing costs to the loan amount or paying a higher interest rate for the mortgage.
When you add closing costs to the loan, you will pay interest on those closing costs for the life of the loan. Paying the closing costs out-of-pocket will help you reduce the long-term costs of the refinance.
5. You won’t need to pay PMI
Private mortgage insurance (PMI) is required for many homebuyers who can’t afford a down payment of 20% or more. PMI is insurance that pays the lender if you default or stop making payments on your home loan.
You can build equity by paying down the mortgage and the home appreciating in market value. If you get an appraisal and have enough equity in the home, you can refinance the house and request to stop paying PMI. PMI premiums can cost as much as 2.25% of your mortgage amount, so removing PMI can save you hundreds of dollars a month.
Refinancing isn’t the only way to remove PMI, however. Once your mortgage balance has fallen to 80% of your home’s value when you purchased it, you can ask your lender to remove PMI. Lenders automatically remove PMI when your balance is 78% of your home’s original value.
6. Your adjustable-rate mortgage is about to adjust
An adjustable-rate mortgage is a great type of loan during the first few years when the interest rates are low. But as the interest rate starts to adjust (and potentially increase), you may want to refinance for a fixed-rate mortgage.
An adjustable-rate loan typically has a fixed interest rate for a period of time. It’s important to note when that rate will adjust because your mortgage payment could go up at that time. You may be able to refinance for a better, fixed-rate loan. This will help you save money and step out of the limbo that adjustable-rate mortgages can leave you in.
7. It will put you in a better financial position
No one knows your financial situation better than you. Evaluate whether or not a refinance will put you in a better financial position. This may be reducing monthly payments, shortening the length of your loan, or reducing the total interest paid throughout the loan. Your situation may also be improved if you can pay down debt or avoid high-cost debt when needing to fund home repairs or other big-ticket costs.
Keep in mind that the mortgage is one part of your bigger financial picture, and while it is a significant part of it, it isn’t all of it. If you can pay down expensive credit card debt by doing a cash-out refinance, you can pay that high-interest debt off faster with less interest owed. That’s one example of improving your financial position.
6 reasons not to refinance your home
Although refinancing your mortgage to lower your interest rate sounds like a good idea, it is not the right move for everybody. Below are some of the reasons you shouldn't refinance your mortgage right now:
1. You lose protection from creditors
In some states, the mortgage to buy your home is considered non-recourse. This means the lender cannot sue you for the difference between the loan balance and the value of the property in case they foreclose on the home. When you refinance your home, you lose this protection.
2. You’re planning to move in a few years
If you are planning to move or pay off your mortgage in a few years, there might not be enough time for the interest rate savings to make up for the closing costs of the refinance. You may be better off just paying extra to reduce your mortgage balance.
3. Your existing mortgage has a prepayment penalty
Most mortgages today don't have prepayment penalties. However, if your mortgage is older, you may still have one, and it can become an issue when you refinance. A refinance still may make sense even if you have to pay this penalty; you just need to include the prepayment penalty cost in your calculations.
4. You want the money for luxury purchases
Most experts agree that doing a cash-out refinance to splurge on luxury purchases or funding a vacation is a poor choice. You're paying a long-term debt for a short-term purchase.
5. You want to fund your investments
With the stock market near all-time highs, you may be interested in investing more money. But pulling money out of your home to invest in a volatile stock market can be very risky. Instead, consider refinancing your home to save money, then invest those savings every month into a robo-advisor or brokerage account.
6. Your income is not stable
Refinancing your home requires a stable paycheck. The lender will ask for paystubs and W-2s at the beginning of the financing process, and then they check with your employer one more time before the mortgage closes. If your job status is uncertain or your income varies widely, it may be difficult for you to get approved.
Is there a catch to refinancing your mortgage?
Most borrowers will refinance their mortgage because they want lower monthly payments and lower interest rates. The catch is that you often have closing costs that you have to either pay out-of-pocket or roll into the loan value. When it’s rolled into the loan value, you will pay interest on those closing costs, making it more expensive in the long run.
How does refinancing affect your credit?
The impact of refinancing on your credit score is likely to be minimal. You may see an initial dip when the lender runs your credit. This dip is often negligible (about five points or less). If you replace one loan with the other without adding anything to the balance, refinancing might have no real net effect.
Your credit score may decrease if you add to the loan balance. Likewise, your credit score may improve if you pay down the mortgage in the refinance.
What are the benefits of refinancing your mortgage?
There are multiple benefits to refinancing your mortgage. You may get a lower interest rate, a lower monthly payment, a shorter term, or cash out of your home to pay off debts or finance other needs.
For most people, reducing their interest rate or getting cash out of their homes is a great reason to refinance. Take a look at all the numbers before you refinance, and make sure you know all the steps in how to get a loan, so there aren’t any surprises along the way.
If refinancing seems like the right move for you, check out our list of the best mortgage refinance companies.
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