Reasons To Refinance Your Home
Lots of commercials on tv, radio, and internet are causing people to stop and ask themselves a very common question; “should I refinance my mortgage?”
While it is not possible to give an exact answer to every single person, we can provide some general guidelines. The guidelines will help you to take a serious look at your current financial situation and give you the info you need to make a fact-based decision. With these guidelines, you may be on the way to saving some money thanks to a home mortgage refinance.
Understanding a Mortgage Refinance Loan
Refinancing a mortgage loan is very simply getting rid of one loan with a new loan. The new loan will have different terms.
Different terms can come in multiple ways such as:
- A different period of time to repay the loan. For example, changing from a 30-year fixed loan to a 15-year fixed loan.
- A different interest rate. For example, your current mortgage has a 6.25% interest rate, but your new loan will have a 4.5% interest rate
- A different loan amount. Perhaps you originally financed $200,000 when you bought the home 6 years ago. Thanks to a rise in home values, the home is now worth $240,000 and you wish to refinance to tap into the extra equity.
With a refinance, the old loan is completely paid off and the new loan takes its place.
How Small Changes Can Add up to Major Differences
Some people may ask “how can a difference in only 2% make a noticeable difference in a mortgage? That is an excellent question.
Let’s look at some real numbers to illustrate how small changes in interest rates can impact your budget.
Let’s assume that someone bought a home and financed $205,000 with a 6.5% interest rate for a 30-year fixed term. Just to make the example simple, let’s assume that the customer has paid on the loan for 5 years and wishes to refinance while including the closing costs in with the new loan. This will make the new loan the same $205,000. Finally, the borrower decides to get a 25-year term on the new loan.
Monthly payment (principal & interest only)
The new payment is $156.28 cheaper per month. That is a nice savings amount.
However, the real savings show up over the course of the loan. Over the next 25 years, that $156 monthly reduction will save the borrower $46,884! That is why people refinance to a lower interest rate.
Basic Criteria for Getting Approval on Mortgage Refinance
Each mortgage lender will have some slightly differing requirements for the multitude of refinance options that are available. The differences are usually referred to as mortgage overlays, which you can learn more about on our blog.
In most cases, the lenders will be judging mortgage applications on the following items
- Available equity – most loans will limit the borrower to getting 90% of the home’s appraised value. Therefore, you will need to have some equity to cover the amount to pay off the existing mortgage along with the closing costs. Some loans, such as FHA and VA will allow a higher loan to value ratios, but certain restrictions will apply.
- Mortgage payment history – since lending money is an assessment of risk, the lender wants some assurance that you will repay the loan. The best indicator of that is your payment history on your current mortgage loan. If you have made any late payments on the mortgage over the last 12 months, you may have trouble getting approved for the loan.
- Credit score – besides the payment history on the mortgage, the mortgage lender will also review your entire credit report. They want to make sure that other bills, such as credit cards, student loans, and automobile payments are being made on time as well.
- Available income – Finally, the mortgage lender will want to compare your current income to the existing debt you have along with the proposed new mortgage payment. The goal is to make sure the new payment is not a burden for the borrower.
If you can meet these basic criteria you should be able to get approved for a refinance loan.
Costs of Getting a Refinance Loan
Different items will dictate the cost of a refinance. The location of the property, any fees assessed by the lender, as well as the amount of money being borrowed will all play a role in determining the closing costs for the mortgage.
Most lenders will advertise that their closing costs range between 2% and 5% of the amount being borrowed. If a person is borrowing $250,000 then they could expect to pay between $5,000 and $12,500 for the closing costs.
Some of the items that are typically charged for a home refinance include
- Appraisal of the home
- Title search conducted by a local title attorney
- Home inspection
- Credit report fee
- Origination fee charged by the lender
- Closing document preparation fee charged by title attorney to close the loan
This list is not all-inclusive, but simply a list of the more common items. Your lender can give you a full list with a Loan Estimate prepared at the time of your loan application.
Reasons to Refinance
As mentioned before, refinancing a loan means replacing an old loan with a new loan. With that in mind, there are many reasons to consider refinancing a home loan.
- Shorten the overall mortgage term – Many lenders offer mortgage loans with 10, 15, 20- and 25-year payback periods. As shown in the earlier example, refinancing a loan with a lower interest rate, and getting a slightly shorter term can save a bit of money monthly now while saving you a considerable amount of money in the long run.
- Lower the overall interest rate – in the example above with the $205,000 mortgage amount we showed the savings if the borrower chose a shorter term to pay back the loan. If the customer decided to get another 30-year loan, the monthly payments would decrease to $1,038.70 which would save the customer $257.03 per month. This is normally the reason people choose to refinance a home. Use our handy payment calculator to calculate your new payment.
- Change from an adjustable-rate to a fixed-rate – Some people may have purchased a home with an adjustable-rate loan for various reasons. Perhaps they thought they would sell the home within a short time or they were rolling the dice and hoping that mortgage rates would drop. Changing from an adjustable-rate to a fixed-rate will bring definite peace of mind to these customers and help them budget better in the future.
- Use available equity for other expenses – As home values rise, people often look for a way to tap into that equity and use the money for other expenses. By getting a cash-out refinance loan, borrowers can normally use the excess funds to pay off other debt like credit cards or student loans, or they can do some improvements to the home, or they can take a long overdue vacation to an exotic location.
- Combine a 2nd mortgage with a 1st mortgage – While this is not a common way to buy a home anymore, some people have used a combo mortgage when they purchased their home. The 1st mortgage is normally 80% of the home’s sale price and the 2nd mortgage can be anywhere from 5% to 20% of the home’s sale price. The 2nd mortgage will have a higher interest rate than the first. After the borrower has paid down on the loan a bit, and the home has appreciated, the 2 mortgages can be combined into one loan and get one, low-interest rate payment.
Most people that choose to refinance a mortgage will fall into one of the above scenarios. With a rate quote and loan estimate from your local lender, you can find out if a refinance will be a good decision for your current needs.
How Long Will It Take to Recover the Costs of the Refinance
Along with the savings in interest, you also need to consider the costs of the refinance and how long it will take to recover those costs.
As mentioned in a previous section, the closing costs can cost between 2% and 5% of the new loan. Using the same example as before, suppose a person takes out a new loan of $205,000 with closing costs of $4,100 and the new monthly payment is saving them $257.03 per month. In this instance, $4,100 divided by $257.03 equals 15.95, or about 16 months. If the borrower plans to stay in the home for longer than 1 year and 4 months then the refinance will save them money.
This analysis is called a break-even calculation. It is important to understand if you are thinking about moving out of the home within a short period of time.
One Important Factor to Keep in Mind
There is one very important item to keep in mind when refinancing a home. If you are getting cash from the refinance and using that cash to pay other debt, it is vitally important to refrain from adding more debt. Otherwise, you will put yourself in a worse situation.
Here is an all too common example, from years of working with homeowners.
Suppose a married couple has a nice home with enough equity that they can refinance their mortgage and get $25,000 cash along with reducing their mortgage payments by $200 per month.
The couple decides to use the cash to pay off a few credit cards along with their older car loan. By paying off the cards and their vehicle loan, they have removed $400 in monthly payments, bringing their monthly savings up to $600 per month.
A year goes by, the old car is not working well, and the couple decides to trade it for a much more expensive car. Let’s assume the new car has a payment of $487 per month. And they end up maxing out all their credit cards that were formerly paid off.
Now, just 12 months after refinancing, their monthly obligations are HIGHER thanks to the new car loan and credit card debt.
Don’t fall for this trap. Make sure you are disciplined enough to make sound financial decisions going forward so that a refinance does not eventually put you in a worse situation.
Summing Up Should I Refinance My Mortgage?
Hopefully, this article has answered your questions and given you the proper framework for considering a mortgage refinance. With the right goals and the right choices, getting a new mortgage can help you achieve your financial goals and save some money at the same time.
Additional Helpful Resources for Homeowners:
As a homeowner, saving money should always be top of mind. There are many ways for homeowners to save money. As this article explores, refinancing is at the top of the list. But what else can you do to save money? Paul Sian has put together a great list of ideas that any homeowner could tackle to save money each month.
Adding value to your home is a must for all homeowners. Even simple things such as landscaping and regular maintenance can go a long way. But did you know that there are things you shouldn’t do that could affect the value of your home? Sharon Paxson explores the 8 things you should avoid so that you don’t affect your home’s value.
Something to think about when calculating whether a refinance is worth it or not is private mortgage insurance. If you currently have private mortgage insurance on your loan, a refinance can get rid of that with enough equity and save you hundreds of dollars a month. If you do not have enough equity for a refinance, there are other ways to get rid of private mortgage insurance, as Bill Gassett explains.
If you are looking for ideas on how to increase your home’s value through landscaping, take a look at this post by Danny Margagliano. Simple things can really make a difference. Whether it’s mowing the lawn, planting trees, or even painting the fence. It’s the little things that can add up quickly.
About the author: This article on “Should I Refinance My Mortgage? Top Reasons To Refinance Your Home” was written by Luke Skar of MadisonMortgageGuys.com. As the Social Media Strategist, his role is to provide original content for all of their social media profiles as well as generating new leads from his website.
We provide award-winning customer service to clients who need to purchase a home or refinance an existing mortgage.