Buying a home is a pretty big deal. Eighty-four percent of Americans say home ownership is a good investment, according to a National Association of Realtors survey. A home certainly might be the biggest purchase you ever make.
Unless you had some serious cash to spare, you probably took out a mortgage to buy your home. Refinancing (getting a new home loan to replace your old one) is something that may have crossed your mind.
Why consider refinancing?
Why would I want to give up my old mortgage and take out a new one?
That’s a great question. You might want to consider a mortgage refi for several reasons. Here are a few common ones:
- Lower your interest rate
- Lower your monthly payment
- Shorten the mortgage term
- Lengthen the mortgage term
- Convert an adjustable-rate mortgage to a fixed-rate mortgage
- Convert a fixed-rate mortgage to an adjustable-rate mortgage
- Access the equity in your home (take cash out)
- Release a borrower from responsibility for the old mortgage
- Add a borrower to the new mortgage
When not to refinance
Although the choice to apply for a refinance always belongs to the borrower, it may not be a good financial move for everyone. Here are a few examples of times you might want to leave your original mortgage intact:
- Refinancing could be a bad move if you’re paying off other, higher cost debt without a solid plan for avoiding a repeat of the same situation. If you refi and tap your equity, pay off your credit cards, and then run the balances back up, your financial situation will only be worse.
- Refinancing may not be a good move if your new loan term stretches into your retirement and you know your income will go down. Thirty years is a long time. Think about what you want your budget to look like in the last ten before you make your decision.
- Refinancing for a lower rate may not be a good move if you plan to sell the home before you break even on loan costs.
- You might want to postpone your refinance if your credit isn’t excellent since you could take steps to improve your credit score over the next six to 12 months. A better score could get you a better interest rate so waiting could be a better choice.
If you’re thinking about applying for a refinance, you should know a few basics first. Here’s the deal.
Refinancing can be a money-saver or a money-loser
If interest rates have fallen since you took out your mortgage, refinancing might help you get a lower rate. You could also refinance to convert an adjustable-rate mortgage (ARM) that is about to become more expensive to a fixed-rate mortgage (FRM) with terms that won’t fluctuate. Borrowers sometimes do this when the initial interest rate period ends on the ARM.
A refinance can lower your monthly payment as a result of a lower interest rate or a longer loan term. Whether you save money on your monthly payment, the total interest charges over the life of the loan, or both depends on the refinance loan terms.
Say you took out a 30-year, $250,000 loan ten years ago at 5.125 percent. You still owe about $204,117. If you were to refinance into a new 30-year loan at 4.47 percent for 30 years, you could trim $331 per month off your payments. Great, right?
But starting over with a new 30-year loan puts you back at square one in terms of paying off the loan. Paying the first loan for ten years and the second loan for 30 years will result in more than $44,000 of additional interest charges. Over time, this is a money-losing scenario.
Now, say you had the same loan but you refinanced into a 20-year term at 4.47 percent. That only cuts your monthly payment by about $73 but by the end of the loan term, you would have saved more than $17,000 in interest charges. A 15-year fixed-rate mortgage could save you even more, but your monthly payment would go up.
Whether you have more money in your pocket every month or reduce the overall cost of the loan depends on the loan you choose to seek.
If your budget can handle a higher payment, paying more each month could help you build equity faster, assuming your home’s value holds steady or improves. Equity is the percentage of your home you own free and clear.
Calculating the break-even point
It’s important to understand the costs of your loan because a refinance is not guaranteed to save you money. Mortgages are not free.
Let’s go back to our hypothetical example. You take the 20-year loan mentioned above and your closing costs amount to 2 percent, or $4,082. With a monthly out-of-pocket savings of $73, you’ll recoup your closing costs in about 56 months. That’s your break-even point. If you sell the home sooner, you could lose money by refinancing to the lower rate.
You could tap into your home equity with a cash-out refinance (but you might not want to)
With a cash-out refinance, you get a new mortgage for more than you owe on the home. The difference represents your equity. At closing, you get the equity in the form of a check.
Collectively, American homeowners had more than $6 trillion in tappable home equity as of September 2018. So you might be wondering why you might want to consider taking yours out of your home. After all, building equity builds wealth, right?
The simple answer is that a cash-out refinance can put cold, hard cash in your hands, and that may be a priority for some people. It’s money you could use to:
- Consolidate or pay off debt, including student loans
- Make home improvements or repairs
- Cover college expenses to go back to school (or pay for education expenses for your kids)
- Buy a second home or other property
- Pay medical expenses
- Meet working capital needs if you own a business
…or cover just about any other expense.
The amount of equity you can access with a cash-out refinance varies based on the type of mortgage you have.
- With VA loans you may be able to borrow up to 100 percent of the home’s fair market value.
- FHA loans allow you to get a cash-out refinance for up to 85 percent of the property’s value.
- Limits for conventional loans, meaning those backed by Fannie Mae or Freddie Mac, typically range from 65 to 90 percent of the home’s value.
USDA loans do not come in the form of a cash-out refi. If you’ve got a USDA loan and want cash out, you’d need to apply for a different kind of mortgage, which may mean giving up benefits associated with your original loan.
Cash-out refinance downsides
Some people say no debt is good debt. If your goal is to work toward total debt freedom, you might want to think twice about increasing the amount of money you owe on your home.
You should also think twice about using a loan secured by your home to pay for things unrelated to the home and its value. Want that addition? Okay. That addition may add value to your home. If you can’t pay the mortgage, you might be able to sell it and recover all the money you owe. On the other hand, if you want to pay your child’s or grandchild’s tuition, there might be a better financial strategy to explore. One that doesn’t put the roof over your head in jeopardy in the event of default.
Remember that when you take a cash-out refi, you own less of your home. If you decide to sell the home before the loan is paid off, you may not pocket as much money as you would have if you had stayed in your original loan.
What does it cost to refinance a mortgage?
Refinancing a mortgage means paying closing costs, just like you did when you got a mortgage the first time. Expect closing costs to run between 1 and 5 percent of your loan balance.
In 2017, Bankrate found that average closing costs nationwide amounted to $2,084. This includes document fees and third-party fees for things like credit reports and an appraisal, but not property taxes, homeowners insurance, HOA fees and other prepaids that are required but not charged by the lender. If the previous sentence left your eyes glassy, suffice to say that the $2,084 only accounts for some of the closing costs on the average mortgage.
Closing costs typically include:
- Loan application fees
- Loan origination fees
- Credit report fees
- Title insurance
- Document preparation fees
- Recording fees
- Attorney’s fees
- Discount points if you’re paying them
Can you get a no closing cost refinance mortgage?
No closing cost loans are advertised. Are they for real? Not exactly.
In some cases where there are no closing costs to the borrower, the costs are rolled into the loan. In other cases, the lender charges a higher interest rate on the loan in exchange for paying the closing costs. In other words, the borrower pays for the loan one way or the other.
Even so, a no-closing cost loan might be attractive to you if you want to refinance your mortgage without paying anything out of pocket. To make the best decision for you, take the time to calculate costs under all of the different scenarios you’re considering.
How to qualify for mortgage refinancing
Mortgage lenders examine several factors to make mortgage financing approval decisions. Here’s a quick checklist of things you’ll want to review before you apply:
- Your income
- Your credit score
- Your debt to income ratio (how much of your paycheck goes to debt repayment each month)
- What your monthly housing costs will be if the loan is approved
- Any equity you have in the home and the loan-to-value ratio (how much you owe on the home compared to its value)
Every lender sets its own guidelines for qualification. Consider shopping around with at least two lenders before you choose a loan. Comparing lenders can give you an idea of which loans you’re most likely to qualify for. It’s also a chance to compare rates and terms.
Is a mortgage refinance right for you?
A refinance can be a smart move in certain situations. You might get financial relief right now from a lower payment, or significant money savings over time from a lower interest rate. Refinancing might help you lock in a fixed-rate loan, or cut financial ties with your former spouse. Whether it makes sense for you depends on your reasons for refinancing and what you stand to gain.
If you think a refi might be a good option, consider talking to a mortgage broker. Ask friends and family for referrals, or call your bank’s mortgage department. A mortgage professional can help you explore options that might meet your needs.
While you consider your refinance options, review your financial big picture to see if there are any other steps you can take toward your goals. When you make a big financial commitment, it’s important to consider “what if” scenarios. A mortgage is a significant liability, and it’s smart to consider how your family would stay financially afloat if something were to happen to you before the loan is paid off. For many people, a term life insurance policy that covers your for a specific time period is an affordable way to provide a financial safety net during the time of life we need it most.
Rebecca Lake is a freelance writer specializing in personal finance and small business. She lives on the North Carolina coast with her two children. The opinions expressed in this article are the author’s own.
Haven Life Insurance Agency offers this as educational information only. Haven Life does not endorse services and/or strategies discussed here.Haven Life does not provide legal advice or advice on banking or mortgages, and this information should not be relied upon as such. Individuals are encouraged to seek advice from their own legal advisors or mortgage professionals.