A properly refinanced mortgage can be the gift that keeps on giving, but how do you know when it’s the right time?
Refinancing your mortgage can save a lot of money, but the decision to refinance a home loan should not be taken lightly. After all, a home is often your largest single asset, and a mortgage is often your largest single liability. So, when is it time to refinance your mortgage?
What is refinancing?
Refinancing a loan involves swapping out of your current loan for a new loan that saves you money. Often, homeowners start to look into refinancing a home loan if the new loan’s interest rate is 1% lower than their current mortgage’s interest rate.
This seemingly straightforward answer is not always the best strategy, however. There are several other important factors to consider. Because your home is often your biggest asset, it is important to get it right.
Why refinance a home loan?
Homeowners often look into refinancing a mortgage to reduce the interest rate on an existing home loan. Locking in a lower rate can save money by lowering your monthly payments and by increasing the speed at which you build equity in your home.
Lower monthly payment
For a $380,000 home with a 20% down payment, a 30-year fixed-rate mortgage that has 4.625% interest rate would have a monthly payment of about $1,563 — excluding taxes and home insurance.
But if you lower the interest rate 1%, the monthly payment would fall to about $1,386 — assuming that the financial health and credit history of the borrower remains the same.
Under this example, a 1% drop in interest rate would yield roughly $2,124 in savings a year.
Shorter loan term
Shortening the term of a mortgage is another big reason to refinance. During the first 15 years of a 30-year mortgage, the bulk of a mortgage holder’s payments are on interest.
For example, on a home valued at $380,000, moving from a 30-year fixed-rate mortgage to a 15-year fixed-rate mortgage with a 4.625% interest rate, would increase monthly payments from $1,563 to $2,345.
However, shortening the term of the home loan would save the mortgage holder $140,565 in reduced interest payments. This savings can be greater if a lower interest rate is also locked in when the refinancing occurs.
With fixed-rate loans the interest rate is set for the life of the loan, typically 15 years or 30 years. Adjustable rate mortgages (ARMs) usually start out as fixed-rate loans and after a few years they switch to variable-rate loans. A holder of an ARM can benefit from declining rates, but if rates rise, monthly payments will rise as well.
Some homeowners refinance an ARM to a fixed-rate mortgage to limit the uncertainty around future payments. Conversely, some mortgage holders convert from a fixed-rate mortgage to an ARM. Often, ARMs offer lower monthly payments since the interest rate is fixed for a shorter period.
How to decide if you should refinance
Check your existing mortgage document
Paying down a mortgage quicker works best if prepayment penalties are not part of your current loan; prepayment penalties might make your refinancing prohibitively expensive. Although prepayment penalties are becoming more uncommon, they still exist and they can vary significantly.
Provided that you aren’t living paycheck to paycheck, earmarking your tax return or any extra funds available to your mortgage often makes sense. Simply paying your mortgage biweekly — essentially making one extra mortgage payment a year — can yield a big personal return on investment.
For example, if the 30-year fixed-rate mortgage on your $380,000-priced home had a 4.625% interest rate and you made biweekly mortgage payments each year, you would reduce your total payment period by about four-and-a-half years and you would save about $45,000 in interest.
Consider the new tax reform changes
Whether you’re refinancing your home loan to cover expenses like a remodeling project or paying for your child’s college education, it’s always a move that should be taken with extreme caution.
The new tax reform package, signed into law in December, eliminates the interest rate deductibility of some home equity debt. The new tax package also limits certain homeowner’s interest rate deductibility. However, for new loans in 2018, if you put the money back into your home, you can generally deduct the interest you pay on it. But if you use the money to pay for things like credit card balances or a vacation, you can’t deduct it.
Homeowners with mortgages valued higher than $750,000 are impacted most by this change. Previously, interest rate deductibility was restricted on mortgages over $1 million.
For your averaged-priced $380,000 home with a 30-year fixed-rate mortgage with a 4.625% interest rate, the new tax law has no effect. There are other changes — on property tax and state tax deductibility rules — that may be relevant for homeowners, however.
Your home loan refinancing options
The size of your mortgage loan and whether that loan is part of a government program determines its loan type. The type of loan that you are eligible for is determined by your credit history, the amount of your loan, the property type and whether you served in the military. Common loan types include conventional mortgages, VA home loans, and FHA mortgages.
Banks or private lenders consider a borrower’s credit history, debt-to-income ratio, and down payment when evaluating a conventional loan application. Down payments can be as low as 5%, but often borrowers put down 20% or more to avoid having to get private mortgage insurance (PMI).
PMI rates often range between 0.3% and 1.2% of the loan amount per year, and PMI premiums can either be added to a borrower’s monthly mortgage payments or they can be paid with a lump sum payment. Borrowers are required to pay PMI until they have 20% equity in their home and therefore a loan-to-value (LTV) ratio of 80%.
LTV is the amount of money borrowed divided by the value of the home at purchase, and it is one indicator of the riskiness of the loan for the lender. PMI exists to lower the risk for the lender.
Conventional loan borrowers also have to pay lender and other third-party fees. The actual property is a factors into the closing costs because the closing costs typically include prepaid property taxes and homeowners’ insurance. Borrowers typically pay these costs upfront at the closing.
Usually, the best mortgage rates are reserved for those with credit scores above 720, and individuals with scores below 620 have a harder time finding a mortgage.
Federal Housing Authority (FHA) loans are aimed at homeowners who do not qualify for VA loans and who do not meet conventional loan requirements.
FHA loans require borrowers to put down 3.5% of the property’s purchase price. Borrowers also usually need to have a credit score above 580 and a debt-to-income ratio lower than 43%. Closing costs for FHA loans usually come to about 2% to 5% of the purchasing price, and these fees typically include a lender’s origination fee, a deposit verification fee, attorney’s fees, appraisal fees, title insurance, property survey, documentation preparation, home inspection and more.
Homebuyers with FHA loans are required to take out mortgage insurance, commonly referred to by the acronym MIP. Borrowers with FHA loans typically face an upfront mortgage insurance premium (MIP) and an annual premium that is paid in monthly installments until the borrower has 20% equity in their home.
The Home Affordable Refinance Program (HARP), which is due to expire at the end of this year, is an Obama-era government program that was created by the FHA to help homeowners refinance. To be eligible for HARP, homeowners must be current on their mortgage payments, have little to no equity in their home and they must owe as much — or more — than their home is currently worth.
With HARP refinancing, no minimum credit score is required. Also, closing costs can be rolled into the new loan to limit the amount of cash due at the closing.
VA home loans
The US Department of Veteran Affairs (VA) runs a mortgage program that helps active-duty servicemembers, surviving spouses and veterans purchase a home without a down payment. To prove eligibility for the program, a VA home loan borrower needs to present a VA home loan lender with a certificate of eligibility.
To qualify for a VA loan, VA home loan borrowers also have to show that their source of income is reliable and is enough to cover monthly expenses. Banks and private lenders make these home loans, and the VA guarantees them.
Although VA loans do not require a minimum credit score, having a good credit score will typically mean that you’re offered a better interest rate. VA loans usually have a lower fee structure than other home loans, and VA loans don’t always require a down payment or mortgage insurance. Sometimes VA loan amounts are capped.
Compare lenders who can help you refinance
What to consider before refinancing
Do the math
Your credit score, LTV and your debt-to-income ratio are three of the most important parts of your loan application. But other factors, like switching jobs in the middle of refinancing or taking out a substantial amount of debt during your application process, can threaten your refinancing deal.
Mortgage lenders look at debt-to income ratios because this measurement shows how much money a borrower has left after his or her monthly bills are paid. A debt-to-income ratio above 50% is considered high and undesirable; a debt-to-income ratio that is 35% or lower is ideal. Calculate your debt-to-income ratio with our handy calculator.
Watch out for fees
Perhaps the biggest mistake people make when refinancing is failing to accurately assess the fees associated with refinancing. Refinancing fees might include an application fee, a loan origination fee, an appraisal fee, an inspection fee, home insurance and closing costs — the list truly seems endless.
These expenses must be accounted for to make sure the savings outweigh the cost of refinancing. The fees associated with refinancing often are about 3% to 6% of the loan amount.
To figure out if refinancing is worth it, consider whether you will still be in your home by the time that the monthly savings that are accumulated by refinancing equal the refinancing costs.
By some estimates, nearly half of customers who take out a mortgage fail to shop around. Usually, the first call that homeowners make when looking to refinance is to their current lender, and this makes sense because they have an existing relationship with that lender. But shopping around can help you know your options and — sometimes — get a better deal.
Start your search by going to the Consumer Financial Protection Bureau’s rate checker tool. This tool doesn’t name lenders, but it helps you find the best rates for your profile. With this information in hand, you’ll have a better sense of what to expect when you shop around.
When choosing a mortgage lender, choose wisely. The telltale signs of a good mortgage lender are that they interview you thoroughly, that they complete your application quickly and that they request everything that they need upfront.
- Make sure that your credit score is above 720, that your LTV is at least 80% and that you have a low debt-to-income ratio before you consider a refinancing.
- Be aware of — and understand — all of the fees associated with a potential refinancing.
- Ask questions and shop around thoroughly.
Once you have narrowed down the list of lenders that you want to approach for a refinancing, make sure that the lender you’ve selected is a match by interviewing your mortgage broker or loan officer. Also, make sure the loan product that your lender is recommending suits your financial needs and objectives.
Be sure to ask your loan officer or broker:
- Why the loan refinancing product they’re recommending is a good match for you.
- Ask to have the details of the loan and the refinancing costs explained to you
- Ask for an estimate of all fees and closing costs
- Ask about how quickly you should expect to hear back after you call or email
- Ask how long it will take to complete the refinancing
- Ask if you can receive the closing documents sent to you before the closing so you can review them.
Often, you can judge a mortgage broker’s expertise and helpfulness by how well they answer your questions. The answers to these questions will help you determine the suitability of a loan product and whether it makes sense to refinance now.