Managing Money

When is it worth it to refinance a home loan?

Refinance a home loan
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Lower your monthly payments and lock in lower rates – but consider all the factors first.

A home is often your largest single asset – and a mortgage is often your largest single liability. So is now the right time to refinance your mortgage?

When would I 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 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 a 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 by 1%, the monthly payment would fall to about $1,386 – assuming the financial health and credit history of the borrower remains the same.

In this example, a 1% drop in interest rate would yield roughly $2,124 in savings per 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 over the life of the loan. 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, 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.

My experience with refinancing

My husband and I bought a house we could only afford on two incomes, and I found myself unemployed roughly a year later. So because we were running out of money, we decided to explore refinancing.

I responded to an offer through my mortgage provider, Freedom Mortgage, to refinance my loan which at that point was only a year and a half old. I qualified for a lower interest rate, which brought my mortgage from 3.8% down to 3.25% and shaved off a few hundred dollars of my monthly payments.

Another benefit of refinancing is skipping a mortgage payment – which bought us two months of no payments, and time to figure out my employment situation. I stepped on the gas on my job search and came out lucky in the end with a new job.

Overall the process of refinancing through the same provider was easy. They waived the closing costs and everything was done over the phone and with digital document signing.

Check your existing mortgage documents

Paying down a mortgage quicker works best if prepayment penalties aren’t part of your current loan. Although prepayment penalties are becoming more uncommon, they still exist and can vary significantly.

Provided 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 per year – can yield a big personal return on investment.

For example, if the 30-year fixed-rate mortgage on a $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 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 a move that should be made with extreme caution.

The new tax reform package, signed into law in December 2017, 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 2019, 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 that $380,000 home with a 30-year fixed-rate mortgage and 4.625% interest rate, the new tax law has no effect. However, there are other changes – on property tax and state tax-deductibility rules – that may be relevant for homeowners.

If you need to pay off debt

Many Americans are straddled with high-interest debt. If you have enough equity in your home, refinancing to consolidate that debt into one monthly payment might be a good idea. If the interest rate on a new mortgage is significantly lower than your existing debt, you could save big.

If at all possible, try to keep your loan to value ratio below 80% to avoid paying PMI. Also, be aware that your mortgage payments will increase and you’ll likely be extending the term of your loan. Weigh the pros and cons of your particular situation before making the decision.

What to consider before refinancing

Do the math

Your credit score, LTV and 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 it shows them how much money a borrower has left after their monthly bills are paid. A debt-to-income ratio above 50% is considered high, while a debt-to-income ratio of 35% or lower is ideal. Calculate your debt-to-income ratio with our 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, loan origination fee, appraisal fee, inspection fee, home insurance and closing costs.

These expenses must be accounted for to make sure the savings outweigh the cost of refinancing. The fees associated with refinancing are often about 3% to 6% of the loan amount.

To figure out if refinancing is worth it, consider whether you’ll still be in your home by the time the monthly savings that are accumulated by refinancing equal the refinancing costs.

Shop around

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. 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.

How long you have left to pay

Depending on the provider, you may have a choice between keeping the same number of payments left on the mortgage and dividing the new loan among those payments, or starting from scratch with your original (in my case, 30-year) terms. For example, if you were refinancing with 25 years left on your loan, you could opt to refinance based on 25 years or 30 years. The advantage to starting over is that your payments may be slightly lower depending on how much you have left on the loan, but then again, you’ll have that many more months of payments in the end.

Refinancing checklist

  • Try getting your credit score above 720, your LTV to at least 80% and attaining a low debt-to-income ratio before refinancing.
  • Be aware of and understand the fees associated with a potential refinancing.
  • Ask questions and shop around.

What should I ask my mortgage broker?

Once you’ve narrowed down the list of lenders that you want to approach for refinancing, make sure 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.

Ask your loan officer or broker:

  • Why the loan refinancing product they’re recommending is a good match for you
  • For the details of the loan and the refinancing costs
  • For an estimate of all fees and closing costs
  • How quickly you should expect to hear back after you call or email
  • How long it will take to complete the refinancing
  • If you can receive the closing documents before the closing so you can review them
  • What your options are for new payment terms

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.

Bottom line

When done right, refinancing your mortgage can save you a lot of money in the long run. But it’s a big decision, so carefully consider all of your options before signing the dotted line.

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