You don’t have to stick with the same terms forever when you sign on the dotted line for your mortgage. You can refinance your mortgage at a variety of points, and this can be advantageous in certain circumstances.
However, it can be tough to know when to refinance a mortgage, particularly if you are reasonably satisfied with your current mortgage’s terms and fees.
Read on for more information about what refinancing a mortgage involves and when you should consider refinancing your home’s mortgage to take advantage of potential benefits.
What Is Refinancing a Mortgage?
Refinancing a mortgage involves acquiring a new mortgage loan from a new lender with enough money to pay off your existing mortgage balance, then using the new mortgage contract as the ongoing loan for your home.
For example, say that you have an original mortgage from Lender A for $400,000 with an interest rate of 8%. You can apply for a new mortgage loan from Lender B for $400,000 or your current mortgage balance with an interest rate of 7%.
If approved, you’ll take the money from Lender B to immediately pay off the remaining balance of your mortgage from Lender A, then continue to pay down the $400,000 refinance loan from Lender B with a lower mortgage rate of 7%. This allows you to save on interest payments, as your current interest rate is lower than your initial one by a percentage point.
Refinancing your mortgage works similarly to getting an initial mortgage to purchase a property. However, there’s usually much less stress involved; you don’t have to move, for example. You also don’t have to look for and purchase a home.
However, there are other upfront costs of refinancing to consider, such as closing costs and origination fees. Therefore, you should not take refinancing your mortgage lightly; it's an essential financial decision and an option only when you think it will significantly benefit your financial situation.
Things To Consider Before Refinancing
Before refinancing a home, homeowners should consider three major factors that can impact its financial feasibility and overall strategic wisdom.
As noted above, you do have to pay closing costs when refinancing your mortgage. While these are less than the initial closing costs you must pay when buying a house, they will still add up to between 2% and 6% of the mortgage loan amount.
Depending on the total mortgage amount, these closing costs can eat into your savings or cause financial difficulties in the future.
If you have existing debt that is impacting your overall DTI (debt to income ratio), such as a credit card with a high balance, your lender may request that you pay down this amount in order to close.
In some cases, your lender could cover the closing costs associated with your refinance.
To play it safe, make sure to have a conversation with your lender or mortgage broker about the costs associated with refinancing early on in the process.
Furthermore, you need to determine the break-even point or period before going through with a mortgage refinance. The break-even point is the point at which the savings from a lower interest rate from your new mortgage loan exceed the money you have to pay in closing costs.
You can calculate the break-even point by dividing your closing costs by the monthly savings from each mortgage payment you’ll make with the new mortgage.
For example, if you have a $250,000 loan with 2% closing costs, your closing costs will be $5000. Under the terms of your current loan, you pay $1150. But under the new loan, you'll only pay $950. This results in monthly savings of $200.
When you divide the closing costs ($5000) by the monthly savings ($200), you get 25 months before you reach the break-even point.
Understanding the break-even point for a mortgage refinance can determine whether refinancing is a financially wise choice for you and your family.
Cash-Out Refinance vs. Rate and Term Refinance
Lastly, consider whether you’ll perform a cash-out refinance or a rate and term refinance.
A rate and term refinance is a standard mortgage refinancing where you exchange your current loan with a new one for the same amount of money, typically with a lower interest rate, a shorter term of your loan, or both.
A cash-out refinance is similar, but you can withdraw some of your home's equity in a lump sum. You can then put the money toward anything you like, such as an investment, a home renovation, or paying off high-interest credit card debt.
A cash-out refinance can only be done if you have built significant equity in the home, which is the difference between your home’s current value and the amount you owe.
Both refinance options have advantages for homebuyers, but you should determine which is best for your goals and financial needs before signing on a new dotted line.
When Is It Smart To Refinance Your Mortgage?
Now let’s take a look at some situations where it may be wise to refinance your home’s mortgage.
You Can Acquire a Lower Interest Rate
One of the situations in which to refinance your mortgage is when you think you'll be able to secure a lower interest rate for your loan. This can happen if national or global market rates decrease or other factors, such as new loans being open to you because of an increase in your credit score/credit report or a new job.
A lower rate means you’ll pay less on your mortgage loan over its lifespan, plus enjoy a lower monthly payment to your mortgage lender.
For instance, if you have a chance to get a mortgage loan with a 5% interest rate instead of an 8% interest rate, that could be well worth the closing costs you’ll have to pay in aggregate, especially if your real estate loan term is closer to 30 years instead of 10 or 15 years. Instead of maintaining the higher monthly payments and higher interest rates, it may make sense to refinance.
You Want To Access Your Home’s Equity
In other cases, you might want to refinance your mortgage to access some of your home’s equity.
The equity in your home is the percentage of it that you own from paying down the loan principal or the home’s value you’ve built up so far by making your monthly mortgage payment.
As you pay off your mortgage, you build equity. By accessing your home's equity in a cash-out refinance, you'll have access to an immediate lump sum of money you can use to pay down debt, finance home improvements, pay for a child's college tuition, or anything else.
Even better, cash-out refinance rates are relatively cheap ways to borrow money, compared to using a credit card or personal loan. Note that you can only access home equity via a cash-out refinance if you still have 20% or more equity remaining after the transaction.
For example, if your home is worth $600,000 and you owe $400,000, that means you have $200,000 in equity. If your lender has a max loan to value ratio of 80%, you can borrow up to $480,000.
Your new mortgage balance will be $480,000, which will cover your existing mortgage and allow you to cash-out $80,000 as a lump sum at closing. You can then use the cash-out proceeds to make home improvements, pay off existing debt, invest, etc.
You Want to Payoff Your Loan Faster
The most common mortgage term is 30-years. However, a 15-year mortgage is also an option that allows you to pay less in interest over the life of the loan and pay off your balance faster.
15-year mortgages also offer lower interest rates than 30-year mortgages. However, keep in mind that a 15-year mortgage will come with an overall higher monthly payment than a 30-year mortgage since you are paying off the principal faster.
If you want to payoff your principal faster without refinancing for a shorter-term loan, you can also paydown your balance with a lump sum or by putting more towards your mortgage payment each month.
You Want To Remove PMI
PMI or private mortgage insurance usually kicks in if you cannot initially make a high enough down payment when purchasing a home. For a conventional loan, a downpayment of less than 20% will require PMI.
However, you don’t usually need to refinance your mortgage to get rid of PMI; you can typically request PMI cancellation if you have already built up 20% or more equity in your home.
You Want To Switch From an FHA Loan
FHA or Federal Housing Administration loans usually have mortgage insurance premiums or MIPs that can cost you between $800 and $1050 per year for every $100,000 you borrow. If you don’t make a down payment of more than 10%, you’ll have to pay the premiums for the rest of the life of the loan.
If that’s the case for your mortgage, you can get rid of these insurance premiums by refinancing your mortgage into a new loan that the FHA does not back.
You Want To Change Your Loan’s Type (Adjustable vs. Fixed-Rate)
Lastly, you might want to refinance your mortgage if you wish to change your loan type. Adjustable-rate mortgages may start with lower interest rates, but those interest rates can go much higher depending on market conditions.
In contrast, fixed-rate mortgages offer a stable, steadier interest rates and, therefore, more predictable payments.
If the market conditions are favorable, or you don’t want to worry about your interest rate spiking, you can refinance your mortgage into a fixed-rate loan. In that case, you may benefit from a predictable interest rate payment for the rest of the loan’s term.
As you can see, there are many situations where you might consider refinancing a mortgage, such as when you want to secure a lower interest rate for your home loan or access your home’s equity for cash.
In these cases and others, refinancing your mortgage could be a wise financial decision for you and your family.
Once you refinance your mortgage, you could take some extra cash and put it into a new investment to secure passive income for years to come.
Vaster’s experienced loan officers can help borrowers with this and other financial moves, plus offer advice for your home mortgage and refinancing possibilities. Contact us today to see how we can help you with your financial goals.
When Should You Refinance a Home? | Forbes
When to Refinance Your Mortgage | Investopedia
Cash-Out Refinancing: How It Works, When To Do It | Bankrate