Refinancing your mortgage is a smart move that can save you a lot of money, if done at the right time.
If done at the wrong time or for the wrong reason, a refi might end up costing you more money than what you had expected to save in the first place.
So, when is it worth it to refinance your mortgage? More importantly, what are the factors you should take into account while refinancing your mortgage?
When is it worth refinancing your mortgage?
Mortgage refinancing can make sense under the following circumstances:
- If the interest rates have lowered and if you stand to save a lot of money in interest by restructuring your loan.
- If you are in need of money to consolidate and pay off high-interest debts, to boost your retirement savings, to pay for your children’s education, or to pay for home improvements.
- If you are currently paying private mortgage insurance and want to get rid of it.
Lower interest rates
Refinancing after a drop in interest rates is called a rate-and-term refinance. The the interest rate, the repayment term or both are changed to suit your needs.
For example, mortgage rates in the country have currently dropped by more than 1%. The average interest rate at the end of September on a 30-year mortgage was 3.75%, which is 1.25% lower than what the interest rate was at this time in 2018. Such a decline in interest rates can translate into thousands of dollars in savings for you over a 30-year term period.
If you need money
If you need money for a legitimate reason, such as debt consolidation, funding your children’s education, home improvement, and so on, a cash-out refinance might be a good option for you. It allows you to convert the equity you have built up in your home into cash.
For example, let’s assume that you have a $300,000 mortgage, of which you have paid off $100,000. You now have $100,000 in home equity. If you opt for a cash-out refinance, you might be able to convert up to 80% of that equity into cash.
It means you get a new loan — one which includes the outstanding balance from your original mortgage ($200,000) and the home equity you cashed out ($80,000) — for a total new mortgage of $280,000.
It’s possible that a lower interest rate could mean that your payments will not change. However, review terms carefully. In some cases the payment remains the same as before but the mortgage could be for a longer period of years. That will cost you more money.
To get rid of private mortgage insurance
If you are currently paying private mortgage insurance (PMI), you might be able to cancel it by refinancing your mortgage. Generally, you are required to buy PMI if you cannot afford to pay 20% of the total purchase value of the home as a down payment. PMI is designed to protect your lender in case you default on your loan.
If you have managed to build a sizable amount of home equity and if the value of your home has increased, you might be able to cancel your PMI by refinancing your mortgage. It can reduce your monthly payments and help you save a tidy sum of money over the loan’s term.
Now, let’s a look at the factors you need to consider before refinancing your mortgage.
Interest rates
Generally speaking, refinancing your mortgage is a good idea only if you are able to reduce the rate of interest by at least 1%. Otherwise, you might end up spending more money in the form of closing costs and prepayment penalties than what you will save from refinancing your mortgage.
There are plenty of online calculators to help you figure out if refinancing is worthwhile in your case. However, you will need to know all of the actual extra costs from your lender. Calculators tend to use estimates.
Your home equity
It’s important to build up a sizable amount of equity in your home (at least 10% to 20%) before you apply for a refinance. The more equity you have, the easier it will be for you to refinance your mortgage.
Otherwise, the terms of the new mortgage might not be favorable. In addition, you might also be required to buy private mortgage insurance, which can notably increase your monthly payments.
The value of your home
If the value of your home has increased considerably since it was originally appraised (back when you applied for the mortgage), you likely can easily refinance your mortgage, convert a portion of your equity into cash, and use it for your immediate financial needs.
If, on the contrary, the value of your home has depreciated, you might not be able to refinance your mortgage. Even if you manage to get approved, the lender might ask you to buy private mortgage insurance in order to offset the risks involved to the bank.
Your credit score
A reliable credit score means you can easily secure a lower interest rate and obtain a concrete deal from your lender. A poor credit score, on the other hand, means you are unlikely to qualify for lower rates.
Debt-to-income ratio
If you have a significant amount of debt — so much so that you spend most of your paycheck on debt repayments — you might not be able to refinance your mortgage at all. At the very least you will find it difficult to qualify for a lower interest rate. Ideally, you should not spend more than 36% of your monthly income on all debt repayments, such as car loans, credit cards, and education debt and mortgages.
Repayment term
The amount of money you can save by refinancing your mortgage depends on the length of your repayment term as well. For instance, if you are five years into a 30-year mortgage, it makes little sense to refinance into a new 30-year loan, especially if the difference between your old and new interest rate is less than 1%.
In such a scenario, you are likely to pay more money over a 35-year term compared to what you save by lowering the interest rate.
On the other hand, if you refinance your existing mortgage into a 15-year term your monthly payments will increase significantly but you will save thousands of dollars in interest alone.
Your age
Your age is one of the factors you should take into account before choosing to refinance your mortgage. If you are in your late 30s or early 40s, it might not be prudent to sign up for a new 30-year mortgage, as you might not be able to pay it off before you retire. Rather, you should seek to refinance into a shorter loan term, say, a 20-year or 15-year mortgage.
Refinancing costs
There are a wide range of costs associated with mortgage refinancing. These include application fees, title insurance, title search, origination fees, attorney’s fees, and transfer fees. The monetary amount of refinancing could be anywhere from 2% to 6% of the loan amount.
You need to make sure that you can afford to pay the closing costs before you choose to refinance your mortgage.
In some cases, the lender might offer you a no-cost refinance loan, which does not require you to pay any closing costs. This is a misleading claim, as the cost of refinancing is instead added to your loan amount, in which case you have to pay interest on it for 30 years. If not, you will be asked to accept a higher interest rate to cover these costs.
The fundamentals
Mortgage refinancing can be an excellent strategy to save money on interest payments, pay off high-interest debts, and build equity in your home more quickly.
Refinancing is a major financial decision, however, so you need to consider the pros and cons involved before pulling the trigger. A wide variety of factors can affect if refinancing your mortgage is worthwhile to you.
