6 Things to Consider Before Refinancing Your Mortgage
Mortgage rates have recently fallen to record lows and have dipped below 3% for the first time in 50 years. Many consumers are taking advantage by purchasing a home or refinancing their existing mortgage. Refinancing can be a great way to lower your monthly bill or even take years off your payoff period. Here are 6 things you need to consider before refinancing your mortgage.
note: This article was originally posted in August of 2019. It has since been updated as of July 29th, 2020
1. You are agreeing to a new loan term.
One of the major draws of refinancing your mortgage is to lower your monthly payment. A lower interest rate means less you need to pay in interest. Just be aware that if you refinance into a longer-term loan than what you have left currently, what looks like savings, may end up costing you. For example, let’s say you’ve been diligently paying on your 30-year mortgage for the past 8 years. You decide to refinance in order to tap into the lower interest rates and your lender asks if you’d like the 15-year term or the 30-year term. You don’t want your monthly payment to go up so you opt for the 30-year term. While your monthly payment probably just dropped dramatically, the overall cost of your loan might have just gone up due to interest and the 8 years of payments you just tacked back onto your loan. Just make sure to incorporate these costs when deciding which path to follow. If it works for your budget, your best bet is to refinance down to a lower rate AND a shorter term. Often you can cut years off your payback period and save big on your overall costs.
2. There are usually fees associated with refinancing
Just like when you first purchased your home, the bank charges a fee for doing the work of getting you a mortgage. Closing costs can range anywhere from 2-4% of the loan value as a one-time fee. Some lenders offer a “no-cost” refinance, which usually means that you will pay a slightly higher interest rate to cover the closing costs or will allow you to wrap the fees into the loan itself.
Pay attention to any ‘points’ the lender may charge you to access the interest rate you’re going for. A ‘point’ is equal to 1% of the total loan amount and you’ll hear terms like “quarter-point” or “half a point” thrown about during the process. What the lender is saying is that accessing certain options or rates may cost you a one-time fee of one-quarter or one-half of a percent of the loan amount.
3. Check your credit score and know your debt-to-income ratio
A better credit score means more favorable loan terms. Typically, lenders want to see a credit score of 760 or higher in order to qualify for the lowest mortgage interest rates. Similarly, banks will check your debt-to-income (DTI) ratio in order to confirm that you aren’t over-leveraging yourself. Housing payments generally have to be less than 28% of your gross monthly income to qualify for a conventional loan. You can check your credit score using a free site like credit.com or creditkarma.com
4. Know what your home is worth and determine your equity
The last few years have generally been kind to the real estate market and most homes have gone up in value. Still, if you purchased your home with very little money down, it may take some time to make refinancing worthwhile. Part of the process will be an appraisal by the lender to determine the current value of the property. In most cases, the lender will provide a mortgage for an owner-occupied property at 80% loan-to-value (LTV). This means that you can borrow 80% of the appraised value of the home. If the value has gone up, you gain additional equity and may be able to get more favorable refinancing terms. Ask a local real estate agent or do some searching on Zillow to see if home prices have been going up in your area.
5. You can use refinancing to remove private mortgage insurance early.
Private Mortgage Insurance or PMI is generally required by your lender if you put less than 20% down on your initial purchase. Effectively, you pay a fee every month for the additional risk you bring to the bank. When you have paid down the mortgage balance to 80% of the original appraised value of the home, you can request to have the PMI removed. Unfortunately, lenders aren’t required to remove PMI on a conventional loan until you reach 78% of the original value. This can mean months of extra PMI payments even after reaching the 80% mark. Even worse, PMI on most FHA loans NEVER gets removed. However, If you’re able to refinance the loan and get down to the 80% mark, you should be able to cancel PMI right away. Since technically it’s a new loan, the bank will treat it like you have a 20% down payment already in the house. This can make up for some serious savings.
6. Calculate your break-even point
Ultimately, the best thing you can do is calculate your break-even point. That is the point at which the cost of refinancing with be less than the amount saved by doing so. Then if you know roughly how long you plan to be in your current home you can decide if it’s worth doing. For example, if your refinance costs are $3,000 and you are saving $100 per month over your previous loan, it will take 30 months to recoup the costs and make it worthwhile. If you plan on staying in your current home for at least the next 2.5 years then the refinancing is probably worth your effort.
Final Tip: it’s free to ask your lender for a quote on refinancing and it may give you all the information you need to make a decision on the best course of action.
Need more information about refinancing your mortgage? Tim Ulbrich from Your Financial Pharmacist and I break even more info down in Episode 139 of the YFP Podcast. Check it out!