Refinancing a mortgage refers to getting a new mortgage to replace the original one. It can be a strong tactic for borrowers with good credit history in search of a lower fixed interest rate instead of a variable rate: The first loan gets paid off to allow for the creation of a second loan.
Not only does a reduced interest rate work to save money in the long term; it simultaneously increases the rate at which a homeowner builds equity in their home and decreases the size of their monthly payment. Most loans have closing costs that will be recouped at some point, so it’s worth considering how long that would take.
Consider a scenario: A 30-year fixed-rate mortgage with an interest rate of 9% on a $250,000 home has a principal and interest payment of $2,011.55. That same loan at 4.5% reduces your payment to $1,266.73. It’s a lower payment that puts more money toward the house instead of the loan. To explore further, if the closing costs were $4,000, the borrower would recoup the closing cost investment in 5.4 months (at a savings of $744.82 per month), making it a worthwhile investment.
But this isn’t necessarily a desirable move for people with poor credit or those who don’t understand the mechanisms that make refinancing work. While lenders are required to prove a net-tangible benefit, which means the new loan must be better than the current, it’s important for borrowers to review the terms carefully, especially when the new rate isn’t fixed. If there’s any inherent danger in refinancing, it’s in not vetting the new situation fully.
With that in mind, here are four things worth your close consideration as you contemplate refinancing.
How much equity is already in your home?
Whether the economy is soaring or crashing, it’s not always easy to make payments on your house. Every time you make a mortgage payment, you increase your ownership stake in your house. As home values tend to rise consistently (even if that rate is slowing), this means you own more slices of a figurative pie that’s gaining value over time.
Typically, most traditional mortgages require insurance when the loan-to-value ratio (LTV) is greater than 80%. The lower the LTV, the lower risk the loan is, so borrowers can qualify for lower rates. People are borrowing against their equity and using the cash to consolidate high interest or high payment debts these days.
But if you don’t already own 20% or more of your home’s total equity, you may want to reconsider. You’ll have more hoops to jump through in order to refinance, and you’ll have to take on the added expense of private mortgage insurance (PMI). This might not make a big difference to you if you’re already paying for insurance under your existing loan, but in those instances when homes decrease in value, some owners find themselves having to pay PMI for the first time after refinancing.
How much will it cost to refinance?
Refinancing isn’t free. You can expect to spend up to 3% of your principal (the total amount of money you borrowed) plus any third-party costs such as title insurance, settlement fees, appraisals and taxes. Some lenders, including my company, will offer loan programs with all closing costs credited. You should always ask for that option if it’s what you want, but won’t get below-market interest rates if you do.
There may also be tax implications beyond that. A number of people count on deducting their mortgage interest from their federal income tax bill every year, but refinancing is about harnessing reduced interest. This fundamentally leads to fewer deductions.
This isn’t necessarily a reason to avoid refinancing your mortgage, but it’s good information to have on hand as you arrive at a decision.
How long do you plan to stay in the home?
Time is money, and it’s no different when it comes to homeownership. Your timeline is an important piece of this puzzle because you may have plans to move before reaping the benefits of refinancing. You should probably plan on staying put for a few years at least.
You should calculate your break-even point, when that 3% to 6% is covered by your monthly refinancing savings. Suppose your refinance costs $4,000 and saves you $200 per month — you’ll want to stay there for 20 months in order to cover that expense. Any time spent in your home beyond that puts the savings directly in your pocket.
This is why it doesn’t necessarily make sense to refinance if you’re already planning to move.
How is your credit score?
In simplest terms: The better your credit is, the easier and more favorable your refinancing will be. Pay down (or pay off) small revolving debt before running your credit application. This will typically boost your FICO.
But the act of refinancing itself can also impact your credit score. Your lender will check your credit history, and these inquiries can potentially shave some points off your score. If you should tap your home’s equity and take on more debt, then you’ll increase your credit utilization ratio, and 30% of your FICO credit score depends on how much debt you owe.
You’ll get the best interest rates with a credit score of 760 or better. You can expect to put some money down if your credit is below that threshold.
I agree with my colleagues who say these low mortgage rates are a once-in-a-lifetime opportunity for homeowners. No one expected the world’s events to impact interest rates the way they have. Rates last dropped like this during Brexit in 2016, and the expectation was that they would steadily increase through 2019.
These lower interest rates have sparked a refinancing boom, and plenty of homeowners are leveraging their home equity to borrow at low rates to consolidate high-interest debt, which can save hundreds (and sometimes thousands) every month.