What is a mortgage refinance?
We know that you might not be totally sure about what a mortgage refinance is, whether it’s complicated or necessary or where to get started. Let us break it down for you, so you can decide if it could be a smart move for your finances and if now is the right time to refi.
In the simplest terms and broadest definition, a refinance means taking out a new loan to pay off your existing loan. It can make it possible for homeowners to take advantage of lower market rates, cash out a part of their home equity or change the terms of their repayment in order to reduce their monthly mortgage costs. It can allow homeowners to reassess their current mortgage terms and change them to a plan that fits better.
So, a refinance might mean:
- Paying off a loan faster, thereby paying less overall
- A lower monthly payment due to better interest rates
- A cash advance against the value of your house (to remodel or make repairs, for example)
- The canceling or restructuring of existing insurance premiums (to, say, take advantage of better rates)
And a refinance might not be as time consuming as you might think. You’ll be evaluated on similar areas as you would for your initial purchase mortgage (credit score/history, income/employment and assets) and likely require a home appraisal, but you can expect less paperwork and a shorter time to close (typically 30 days).
Even better? Some refinances don’t require verification. With a “streamlined” refinance program, certain borrowers can bypass the standard verifications through a simplified, speedy underwriting process designed to make things move fast.
When does it make sense to refinance?
As with any financial decision, every situation is unique. But we can point you towards a couple of key considerations to take into account while deciding whether you should refinance. Here are some basic guidelines to help you decide:
- Are the current interest rates at least one full percent lower than your existing rate?
- Do you plan on staying in your home for at least 5 years (more or less)?
- Do you think it’s likely that you meet the criteria to be approved?
Why do you want to refi?
You should consider avoiding unnecessary paperwork, credit checks and appraisals if it won’t ultimately be beneficial. Ask yourself what you’re trying to accomplish.
- Do you want to lower your monthly payment?
- Are you hoping to leverage home equity for a big expense?
- Are you trying to pay off your mortgage faster?
- Would you like to convert your loan from an ARM to fixed (or vice versa)?
- Has your credit remained strong and/or improved?
Read on to learn about how these different types of refinances can work for or against you and to determine the best refinancing solution for you.
So, let’s clarify: Why should you refi?
To lower your monthly payments.
One of the most common reasons to pursue a refi is to lower your monthly payments. If mortgage rates have dropped and the current market is posting better percentages than what you currently pay (this is common during a recession), refinancing can be a very smart choice. It can not only decrease your monthly payment but could potentially allow you to pay off your mortgage faster. Both are financially savvy moves that could mean big savings for you in the long run.
But it’s important to remember that much like your original mortgage loan came with closing costs, your refinance will, too. So, make sure to factor in things like application fees, appraisal, lender attorney’s fees, origination fees and more. Weigh those fees against any potential interest savings and how long you plan to stay in your house to make sure the refinance makes sound financial sense for the short and long term.
To leverage your existing equity.
Don’t forget: Your home has inherent value. You have equity. It’s an asset that you can use as collateral to borrow against. That means that you can use a refinance to cash in against what your home is worth, should you choose to do so.
Why would you borrow against your home equity for cash? There are really good reasons, and a few reasons that should give you pause. Many choose to take out home equity loans for large expenses, like remodeling or home repairs. These can potentially add to the value of your home and even increase your return on investment when you sell.
Here’s how a cash-out refinance works
As an example, let’s say the Walkers want to remodel their home, which will cost $100,000. When they originally purchased the property, the couple borrowed $400,000. Today, they owe $200,000 on their mortgage, which means they’ve built up at least $200,000 in home equity. Over the years, property values have increased in their neighborhood, and their home is now valued at $500,000. The Walkers can convert a portion of their home equity into cash using a cash-out refinance.
On the other hand, borrowing against your mortgage to pay for college or pay off debt can be risky, and should be carefully considered, weighing potential benefits against potential outcomes.
Refinancing to pay off dept isn’t a smart idea unless you’ve already analyzed and rethought the way you spend money. What got you into debt in the first place? Do you make a habit of overspending? If there is a chance that you will start spending money at the same rate after refinancing to pay off debt, you might be better off avoiding temptation, remaining at your current mortgage rate and finding other ways to approach your debt. Start by determining your debt-to-income ratio and let that guide your decisions.
To pay off your mortgage faster.
Refinancing could be a great opportunity for you to save money. If you take advantage of lower interest rates and shorter terms, you could pay off your home faster and for less. But it’s important to make sure that you have the means to pay up on your loan (pay extra), if the terms should change.
“Even if you feel confident about your ability to make bigger monthly payments, your debt-to-income ratio must be low enough to prove to a lender that you can afford it. For most loans, your DTI, including home-related expenses, should be no more than 36%, according to Fannie Mae.”
But refinancing is a big opportunity to save money in the long run, if you feel that you’re in the right fiduciary position. Whether you shorten your loan terms, increase your monthly payments, or merely lock in your loan in at a lower interest rate, you can do your financial health a world of good.
“One of the best reasons to refinance is to lower the interest rate on your existing loan,” according to Investopedia.com. Because that just means that month over month, year over year, you’re paying less to pay off your loan and savings thousands of dollars in the process.
“A mortgage refinance to a shorter-term loan may work if you have few long-term debts and enough money coming in each month to pay your bills (with extra cash to spare). But if your budget is tight or you’re not contributing to other savings, putting more money into your home may not be an optimal long-term strategy. Rather than build home equity faster, it might make better financial sense to put that money to work in other ways, such as a 529 college fund, retirement accounts, life insurance policies or investments.”
To change your mortgage structure.
Perhaps you’re looking to change your mortgage from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage or vice versa. Many first-time home buyers find an ARM attractive, because interest rates can often start out lower than they might with a fixed-rate mortgage.
Many financial advisors will agree that a fixed-rate mortgage is the smarter bet. Knowing that your mortgage rate is locked in regardless of inflation, market fluctuation, recession or industry trends can give you a feeling of security. But, as with any other financial decision, it depends on your goals and timing.
“The rate remains unchanged for a specific amount of time—usually a year, five years, or seven years—depending on the type of ARM. And then, the honeymoon is over. After the too-good-to-be-true fairy tale ends, the lender can adjust your mortgage rate until it reaches the capped interest rate that’s been signed off on, or until they have used the max amount of times, they can make changes to it.
Now, that doesn’t mean an ARM is always a bad idea, either. In fact, it can work in your favor if you’re looking for flexibility, as often an ARM is amortized over 30 years with rates much closer to a 15-year fixed-rate loan. For instance, you could potentially refinance from a 30-year fixed mortgage to a 15-year adjustable-rate mortgage that may mean higher payments now but a shorter period to pay off your loan.
Should you refi?
Bottom line? There are a lot of great reasons to do it and plenty of reasons to hold off. That’s why we’re always here to help you sort through the ups and downs. If you’re ever confused at all about what the best options are for your mortgage loan and what your refinancing options are, please reach out. We’ll explain every option, so you make the right choice to fit you right now.