If you’re a homeowner with a mortgage, you’ve probably heard or read about the benefits of refinancing your mortgage when interest rates are low. What does it mean to refinance a mortgage? Simply put, refinancing a mortgage means replacing a current mortgage with a new mortgage with a better interest rate.
For example, let’s say that you have a mortgage with a 5% interest rate. If you qualify, you can refinance your mortgage and lower your interest rate to 4% or lower.
When you refinance, you take out a new mortgage and use that money to pay off your existing mortgage. You then continue to make payments on your new (refinanced) mortgage. Just like with your original mortgage, you need to apply for refinancing and go through a similar underwriting process.
There are many reasons to refinance a mortgage. The number one reason to refinance a mortgage is to reduce your interest rates. By reducing your interest rate, you’re effectively decreasing the overall cost of your home.
Reducing your interest rate will also decrease your monthly mortgage payments. For many people, that is reason enough to refinance their home.Another valid reason to refinance a home is to remove the need for private mortgage insurance. If you put down less than 20% when you originally purchased your home, then you are required to have PMI (in the United States, at least). Once your equity exceeds 22%, then you no longer need PMI. If the value of your home significantly increases, refinancing your home could push your equity above that 22% threshold and eliminate the need for PMI.
Some people choose to refinance their mortgage to switch to a shorter term. For instance, if you currently have a 30-year mortgage term, you can refinance to a 15-year term. Shorter terms usually come with a significantly lower interest rate (but a higher monthly payment). This is a great option if you can afford it.
Alternatively, some people choose to switch to a longer term in order to reduce monthly payments. In general, we would advise against this unless you are struggling to make your monthly payments. Switching to a longer term will result in lower monthly payments, but you’ll end up paying more in interest in the long run.
If you currently have an adjustable rate mortgage (ARM), you could greatly benefit from refinancing and switching to a fixed-rate mortgage. ARMs can seem like a good idea, but they come with a lot of uncertainty that fixed-rate mortgages do not. Refinancing can help you lock in a lower interest rate.
The final reason to refinance that we will cover here is to cash out on your equity. If you’ve built up a significant amount of equity and your home’s value has increased, you can perform a “cash-out refinance.” This is more complicated than any of the benefits above, and it comes with some downsides. We will cover the pros and cons of a cash-out refinance in the section on types of mortgage refinancing.
Generally speaking, you should consider refinancing your mortgage when current interest rates drop below your current mortgage rate.
If current mortgage rates are less than 1% lower than your current rate, you probably won’t see significant savings. But if interest rates are more than 1% lower than your current rate, you could save thousands of dollars over the course of your mortgage.
But, just because the current refinance rates are lower than your current mortgage rate does not necessarily mean it is a good time to refinance your home. To determine whether or not it is a good financial decision to refinance your home, you need to compare your potential savings with the costs of refinancing (more on that later).
For many homeowners, it can take months, or even years, to recoup the cost of refinancing. This is called the “break-even point.” Once that cost is recouped, all of the benefits of refinancing will go directly to your savings.
For example, if the total closing costs of refinancing your home are $2,000 and your monthly mortgage payment is $200 less because of it, then it would only take 10 months to cover the costs of refinancing. After that 10 months, all of the savings from refinancing go directly to you.
Alternatively, let’s say that the cost of refinancing is $5,000 in total, and you end up saving $100 a month. In this example, it would take 50 months (over 4 years) to break-even.
Since your savings increase over time, it is generally more advantageous to refinance a relatively young mortgage. In other words, you will save more money refinancing a mortgage with 25 years left on it compared to a mortgage that has only 5 years before it’s paid off. That said, you could benefit by refinancing at any stage of repayment.
Just like there are many types of mortgages, there are many ways to refinance a home. The three ways to refinance your mortgage are cash-out, cash-in and rate and term. Deciding which refinance option is best for you depends on your individual needs and financial situation.
Cash-out refinancing is an excellent option if you need cash for something else in your life and want to use your home equity to help you out.
Essentially, you can borrow money to help with other financial obligations by taking advantage of the value of your home. This refinance option requires you to take out a new bigger loan than you currently have, pays off your old loan and give you the difference in cash.
If you can secure a lower interest rate and continue to make your monthly payments, you will end up paying less in the long run.
There are a few different requirements to do a cash-out refinance:
Fair Credit Score:
To qualify for a cash-out refinance loan, your credit score must 620 or above. This is not an excellent credit score by any means; a 620 score actually falls into the Fair range as far as credit is concerned.
Lower than 50% Debt-to-Income Ratio:
Your debt to income ratio is the number of your monthly debts divided by your monthly income. If this percentage is over 50%, you will not be able to take out a cash-out refinance.
Existing Home Equity:
To take out a cash-out refinance, you must already have equity in your home. This means you must have already paid into a good chunk of your current mortgage.
Why would you choose a cash-out refinance?
This refinancing option is great for people who are looking to do a big home renovation. Whether you are looking to optimize the overall use of your unfinished basement, remodel your kitchen or add an in-law suite to the back half of your home, a cash-out refinance could make sense.
You can also use a cash-out refinance to pay off credit card debt. The interest rate in a cash-out will most likely be lower than your credit card APR. Lower interest payments will definitely help you save money in the long run. Average mortgage interest is anywhere from 3-5% versus credit cards anywhere from 14-24%; therefore, you could potentially save thousands of dollars by paying off your credit cards through a cash-out refinance. But, for this to work, you must keep your credit balances to a minimum moving forward.
Cash-out refinances can also be used to pay for a second home or an investment property. You can use the cash from your primary residence and put it towards another property, which will help you stretch your real estate portfolio. Depending on where you are looking to get a second home or investment property, you could make this cash back in a short amount of time. If you plan to make the additional home a rental property, this is a great use of the cash-out option.
A fourth way a cash-out refinance can help you protect your investments and increase your savings. The interest earned on investments can be higher than the interest you owe on your home and help you earn extra cash. This could be a risky move since the market fluctuates, and that is not a guarantee. We strongly suggest you consult your financial advisor before taking steps towards using this cash towards your current investment portfolio. Borrowing from your home might be an easier option than taking a tax hit on your investments.
The final way a cash-out refinance option might make sense is if you own a business and need extra cash. If you need some emergency funds and don’t have excess capital on hand, you can use money from your home to support your company. This could be a perilous move, but it is an option for business owners. However, if cash-flow is a concern, it could make more sense to borrow from your house than trying to take out a business loan.
There are plenty of good reasons to do a cash-out refinance. Still, it’s also essential to understand if you are using this option to help pay off your bad habits (i.e., paying off credit card debt) it is crucial to stick to a financially secure plan moving forward. Because you used your home as collateral and you end up not being able to make the monthly payments, you might lose your home.
It’s also important to know that any new mortgage terms will come with closing costs, make sure you have enough savings to cover these costs and that the refinancing terms are actually saving you money in the long run.
Finally, if you intend to borrow more than 80% of your home’s value in a cash-out refinance, you will also have to get private mortgage insurance. Private mortgage insurance will usually set you back up to 2% of your overall loan annually. Making it even more important to understand how much money you are taking out, how you will use that money and a plan to pay it back on time.
Cash-in refinancing is the contrast to a cash-out refinance.
This refinancing option is where you put more cash towards your existing loan.
Putting more cash towards your existing loan will obviously decrease the amount due and reduces your monthly payments. Which, in turn, should help you pay off your remaining loan faster.
Why would you choose a cash-in refinance?
A cash-in refinance can help improve your loan-to-value ratio (LTV). By improving your LTV, not only do you own more equity in your house, but you can get rid of other monthly payments. Once you’ve paid 20% of your home's value, you do not need to pay private mortgage insurance.
Another motivator for a cash-in refinance is to avoid paying private mortgage insurance. Getting rid of the private mortgage insurance will end up saving you thousands of dollars. This is a required payment until you’ve paid for 20% of your home.
A cash-in refinance can help decrease mortgage rates. Certain lower mortgage rates are only offered when you have a lower loan-to-value ratio.
Just like a cash-out refinance it is important in a cash-in refi.nance to make sure the money you are putting towards your mortgage is the best use of that money.
Before you decide to dump your extra cash into your home, we suggest you research other ways to invest your cash. Are you currently maxing out your retirement accounts? If you are not, you might consider this option first, since both 401K and Roth IRA are tax-deductible. Meaning, you could be saving money by not having to pay taxes and your investments should appreciate over time, earning you more money in the long run.
Don’t forget about taxes. When you refinance you might be saving money on the interest, but remember that interest payments are tax-deductible. Depending on how you refinance, you could fall into a different tax bracket and lose out on the itemized tax benefits.
Lastly, it’s important to understand your home value could depreciate. This is might be the biggest risk in a cash-in refinance. Home values do tend to rise over time; there’s always a chance the real-estate market could crash.
But at the end of the day, by providing more cash, you are able to pay down your loan balance, increase your home LTV ratio and potentially get rid of your private mortgage insurance, making it so you only have to focus on your monthly mortgage payments moving forward. A cash-in refinance has the ability to save you thousands of dollars in the future.
A rate and term mortgage refinance is where you pay off your initial loan and the rate (interest rate) or term (length of loan) changes for your new loan. Or both the rate and the term change, either way, you are getting a new loan that should be more financially beneficial.
Rate-and-term refinancing tends to offer lower interest rates than a cash-out refinance and coincides with a decrease in the overall market.
Why would you choose a rate and term refinance?
This is a great option to consider if interest rates have dropped from the time you originally got your mortgage.
However, rate-and-term refinancing is only available if there are in fact, lower interest rates available. Unfortunately, the overall market has to be down in order for consumers to take advantage of this refinancing option.
There’s a catch though if your credit has increased significantly since your original mortgage, you might be able to get a lower interest rate despite the current market. This is subjective based on personal credit history and does not apply to everyone, but can help you significantly if you qualify.
The rate and term refinancing option can help you lower your monthly mortgage payments. It can also help you pay off your loan faster if you decide to decrease the length, in turn paying less interest in the long run, but you will most likely have higher monthly payments due.
Rate and term refinance is a great option for people who are looking to decrease their monthly payments.
Refinancing a home is much like taking out a mortgage to purchase a new home. Let’s take a look at the refinancing process step-by-step.
The first step of refinancing a home is figuring out if it is the right financial decision. To do this, calculate your break-even point by estimating your potential savings and potential closing costs. During this phase, you should also consider your goals. This will determine the type of refi you go over. For instance, are you just trying to reduce your monthly payments? Or are you trying to switch from an adjustable-rate mortgage to a fixed-rate mortgage?
After you’ve determined that refinancing is the right financial decision, it’s time to shop around with different lenders. You can do this by filling out this quick form, from there, a variety of lenders will reach out with their best loan estimates. This is a great way to get a good rate because the mortgage lends will essentially compete for your business.Keep in mind, the rates that lenders give you now won’t necessarily match your final rate. These numbers will just be estimates based on the information you provide. Lenders won’t be able to determine their final rate until after confirming a few additional variables (like your credit score, appraised home value, etc.)
Now that you have a good idea of the interest rates you can expect, it’s time to submit applications. A refinancing application is just like a mortgage application.You can expect potential lenders to examine your credit and financial history. That means you will more than likely need to provide banking records, W-2 forms, tax returns, etc. This is the information that helps lenders determine your final loan terms. During the application process, the lender may also order an appraisal to determine the actual value of your home. If you had an appraisal done recently, they might forgo this step.
Once your applications come back, contact the lender of your choosing to let them know you want to move forward. Typically during this phase, the lender will “lock in” your rate for a set number of days (usually 30-60 days). When you lock in your rate, the lending company is guaranteeing that your rate won’t go up before your close. Make sure to read the fine print. Some lenders will charge a fee to lock in a rate. Other lenders are very open and will agree to not increase the rate, but they will decrease the rate if variables change.
Now, it’s finally time to complete the paperwork and pay your closing costs. After that is done, the money typically goes directly to the previous lender (meaning that you don’t get all the money deposited into your bank account, the lenders will handle the transaction for you).
After your new lender completes the transaction with your old lender, you will go back to business as usual. You need to continue making payments to the new lender - but with a nice, new interest rate!
Just like with your original home loan, there are closing costs associated with refinancing a home. Similarly, closing costs vary depending on a wide variety of factors. The general guideline is that closing costs are around 2%-4% of the total loan amount.
For example, if you are taking out a new loan for $100,000, your closing costs will be around $2,000 - $4,000.
Refinancing costs include bank fees (like origination or application fees), title costs and third-party costs (like appraisal and attorney’s fees, flood certification, and more).
You should also check if your current loan has a prepayment penalty. These aren’t very common on modern mortgages, but they’re out there. If your mortgage charges a fee to pay it off early, you’ll need to tack that onto your total refinancing costs.
Much like the stock market, mortgage rates fluctuate. While you can research average refinance rates, the only way to know what rate you will get is to contact a refinance lender. To check what sort of rates you qualify for, fill out our no-risk qualification survey.
There are many other factors that are outside of your control that also affect mortgage rates. Those factors include inflation, the Federal Reserve, current bond markets, economic growth, and more. But since you can’t control those factors, we’ll just focus on things you can control.
It is obviously important to secure the best possible refinance rate in order to save the maximum amount of money.
The number one factor that lenders will look at is your credit score. Since you already have a mortgage, we assume that you know what your credit score is. Pay attention to your score and don’t do anything drastic that could affect your score before refinancing (like taking out another loan or defaulting on any debt).
The next thing to consider when trying to get the best rate is the type of loan you are applying for. As we mentioned before, shorter terms typically come with lower interest rates. We should also mention that you should be wary of ARMs. It can be tempting to refi to an ARM with an extremely low-interest rate, but you have to keep in mind that your rate could change at any time.
The final thing you need to do to get the best rate is to shop around and let lenders compete for your business. There are a lot of lenders out there, so don’t just take your first offer. Get a few different estimates and compare the break-even points.
And remember, don’t just pay attention to the interest rate percentage, also look at closing costs, because these could affect your break-even point. Just because one offer is .02% lower than the competition doesn’t mean it will save you money if the closing costs are exorbitantly high.