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Should I Refinance My Home?

When Should I Refinance My Mortgage?

In the first week of January 2018, the average 30-year mortgage rate dropped slightly to 4.1%, from 4.15% the week before. Whenever interest rates fall, many homeowners wonder, should I refinance my home?

Taking advantage of lower interest rates is a favorite reason for refinancing, but there are many other reasons you may want to refinance your mortgage. If you’ve never refinanced before, here’s a look at what you need to know before you decide whether it’s right for you.

Mortgage refinancing basics

Have you faithfully made all of your mortgage payments on time and grown your income since you first applied for a mortgage? In that case, you may think that refinancing should be a breeze. But it may not be that simple.

When you refinance, you’re applying for a new loan. Whether you stick with the same lender or use another one, you’ll be subject to many of the same documentation and verification requirements you experienced when you purchased the home. Not only will you need to prove your income, assets, creditworthiness, job history, and debt-to-income ratio, but your house must also appraise for enough value to support the loan.

How refinancing your home works

When you refinance your home, you take out a new loan to pay off your existing mortgage or mortgages.

Let’s say you bought your home several years ago and locked in a rate that was pretty good at the time. Recently, you spoke to a friend who bought a home. She mentions her rate, and it’s a lot lower than yours. You start thinking home sweet home would be even sweeter if you were paying less for it. That’s where refinancing comes in.

Refinancing could reduce your monthly payments by a whole lot. But like most things, refinancing comes at a cost.

Costs associated with mortgage refinancing

According to the Federal Reserve Board, it’s not unusual to pay 3-6% of your loan balance in refinancing fees. The types of fees and the amount you’ll pay varies depending on the state you live in and the type of loan you choose.

Here are some common fees to expect when closing on a home loan:

Mortgage Refinancing Costs
Fee Description
Application fee Covers the cost of processing your loan request and running your credit.
Appraisal fee Paid to a professional who gives the lender an estimate of the home’s market value.
Attorney fees In some states, an attorney may be required to represent the interest of the buyer and/or lender. This fee is paid to the attorney to prepare and review all closing documents.
Credit report Some lenders charge a fee for accessing your credit information.
Origination charges Upfront charges from your lender for making the loan. Your application fee and underwriting fees may be rolled into this figure.
Notary fees The cost of having a licensed notary public certify that the persons named in the documents did, in fact, sign them.
Points An upfront fee paid to the lender in exchange for a lower interest rate. One point is typically equal to one percent of your loan amount.
Prepaid interest If you close on your loan in the middle of the month, your lender will collect interest on your loan from the closing date until the end of the month.
Private mortgage insurance premium Depending on the type of loan you choose and how much money you put down, you may have to pay mortgage insurance – a policy that protects the lender against losses from loan defaults. Some lenders require an upfront premium, some collect it in monthly installments, and some do both.
Title insurance Provides protection if someone later sues and says they have a claim against your home because, for example, a previous owner didn’t pay their property taxes or contractors were not paid for work done on the home before you purchased it.
Title search A fee paid to the title company to search the public records of the property you are purchasing.

‘No closing cost’ refinances

When you begin your refinancing research, you’ll likely hear about “no closing cost” mortgage refinance programs. No cost may sound good, but there are always costs involved when you refinance a mortgage. The appraisers, attorneys, notaries and other third parties involved in approving your new mortgage have to be paid somehow.

In fact, a more appropriate name may be “no upfront cost” refinancing. Lenders have two methods for providing a mortgage with no upfront costs.

  1. Add all closing costs to your new loan balance. You’ll end up with a new mortgage that is a little larger than your old one.
  2. Charge a higher interest rate. If the lender charges an above-market interest rate, the additional revenue generated by the higher interest rate can be used to pay closing costs in the form of a “lender credit.”

Both methods are counterintuitive to the goal of most mortgage refinancing: saving money. However, lenders have successfully convinced many homeowners to take them up on the offer because the idea of refinancing without paying any money out of pocket – and potentially reducing a monthly payment – is so appealing. But a lower monthly payment and no out-of-pocket costs can end up costing much more in the long run.

Let’s run the numbers to see how this works. Katherine has a $200,000 balance on her existing 30-year mortgage with a 5.50% interest rate. Her monthly principal and interest payments are $1,278.

Katherine is exploring no-cost refinancing. Lender A rolls the closing costs into the new loan balance. Lender B charges a higher interest rate to cover closing costs. Lender C will have Katherine pay closing costs up front.

No Closing Cost Refi vs Traditional Refi
Lender A Lender B Lender C
Loan Amount $210,000 $200,000 $200,000
Interest Rate 4.00% 4.50% 4.00%
Costs Paid at Closing $0 $0 $10,000
Monthly Payment $1,003 $1,013 $955
Total interest paid over 360 months $150,926 $164,814 $143,739

As you can see from the table above, although Katherine would need to come up with $10,000 to pay closing costs out of pocket with Lender C, she’ll save a significant amount in the long run.

If Katherine chooses Lender A, she’ll pay an additional $10,000 in principal, plus more than $7,000 in additional interest charges. With Lender B, she’ll pay more than $21,000 in additional interest charges. Those are some pretty significant costs for a “no cost” mortgage.

What to consider before refinancing your home

Is refinancing a good option for you? To figure that out, ask yourself these questions:

  • Why do I want to refinance?

Many people refinance to get better loan terms including a better interest rate, but reasons for seeking a refi vary. Joe Caltabiano, senior vice president of mortgage banking at BeMortgage in Chicago, says refinancing is a powerful tool that can be used to accomplish many things, including lowering monthly payments, taking cash out of the property and shortening the duration of the loan term. “Many people look at their interest rate and if the rate someone is able to get them is lower, they refinance,” Caltabiano said. But he says that methodology is wrong. “To decide if refinancing is right for you, you need to identify what you are looking to accomplish.”

We’ll delve into good and bad reasons to refinance later.

  • What are the terms of the refinance?

When you bought your home, hopefully, you shopped around and carefully compared the terms of several loans to ensure you were getting the best mortgage available. You should do the same when you refinance.

When you apply for a loan, the lender will give you a Loan Estimate disclosing the loan terms, amount, interest rate and total monthly principal and interest. It also indicates which closing costs you can shop around for and which are fixed no matter which lender you choose. This form can help you compare offers from different lenders.

  • How long do I plan on staying in the home?

If your goal is to reduce your monthly payment to save money, consider whether you plan on staying in your home long enough for the monthly savings to outweigh the upfront refinancing costs.

LendingTree’s refinance calculator can help you calculate your break-even point (the length of time you’ll need to stay in your house to offset those costs). If you plan to stay in your home longer than the break-even point, refinancing makes sense.

  • What will be the long-term impact on my financial situation?

Refinancing to lower your monthly payment or take advantage of a lower interest rate offer may seem like a good idea on the surface, but consider the long-term impact of your decision.

Refinancing to a lower rate could still end up costing you more in the long run because you’re stretching your loan payments out over a longer term. Taking a cash-out refinance — where your new mortgage is higher than your old one, and you get the difference back in cash — can deplete the equity you’ve built up in your home.

When you compare offers, make sure you look at more than just the monthly payment.

Reasons you may want to refinance

Let’s look at some common reasons for refinancing a mortgage and whether they’re a good idea.

Interest rates are down

Many homeowners refinance their mortgage to lower their interest rate. But how much lower does your new rate have to be to justify a refi?

Caltabiano says this is a fairly straightforward calculation, as you just need to determine whether the interest rate reduction will generate enough monthly savings to offset any costs associated with the refinance. A tool like the refinance calculator can help you compare your existing loan to any new loan offers.

Your credit score is up

Even if interest rates haven’t changed, you may be able to lower your rate if your credit score has improved since you last applied for a mortgage.

According to myFICO’s loan savings calculator, mortgage rates can vary by nearly 1.6% based on your credit score. Again, consider whether lowering your rate will generate enough savings to offset the cost of refinancing.

You need to lower your monthly payment

If your monthly mortgage payment is straining your budget, you may want to consider refinancing to extend the term of your loan and decrease the amount you pay per month.

For instance, say you’ve had your existing mortgage for 10 years. Even if you keep the same interest rate, you can lower your monthly payment by stretching out the remaining balance over a 30-year repayment term versus the 20 years remaining on your existing mortgage, but this isn’t necessarily a good thing. You’re not actually saving money in the long term; you’ve simply added another 10 years of payments. You’ll end up paying a lot more in interest, due to the additional decade of payments.

You want to convert an ARM to a fixed rate mortgage

If you’re currently in an adjustable-rate mortgage (ARM) and interest rates are on the rise, it may make sense to refinance into a fixed-rate mortgage.

You may have been motivated to buy your home with an ARM because many ARMs start with lower interest rates than fixed-rate mortgages. Perhaps the rate was even locked in for a number of years. But when this introductory period is over, if interest rates are up, your monthly payment will likely go up, too.

If you aren’t comfortable with a higher monthly payment, refinancing to a fixed-rate mortgage can offer reliable payments and peace of mind.

You want to cash out equity in your home

Homeowners with considerable equity in their home may be interested in tapping into that equity to pay off other debts, finance some major home improvements, pay for a child’s education or fund another big expense.

Caltabiano says it makes sense to do a cash-out refinance, even if the interest rate you have is currently lower than the new rate you’re being quoted. “The logic here,” Caltabiano said, is “interest rates for borrowing against your home will be much lower than other debts you may have, such as credit cards, student loans, car loans, etc.”

However, Caltabiano points out that while you may be able to lower your monthly payment, you’ll spread out your payments over a longer period of time, which could end up costing you more in the long run.

You want to shorten your loan term

Refinancing isn’t always about lowering your monthly payment. In some cases, you actually want your mortgage payments to go up.

If you recently increased your income, you may be interested in putting that extra cash toward your mortgage so you can pay it off sooner. Caltabiano says this is usually the option that makes the most sense. You can save considerable money over the life of the loan because shorter-term loans typically come with lower interest rates.

But again, run the numbers to make sure the savings are there. If your current interest rate is lower than you’d be able to get with a new loan, you may be better off simply making additional principal payments towards your existing mortgage and avoid the cost of refinancing. It also gives you more wiggle room in your budget for unexpected costs.

The bottom line

Refinancing can be a good way to save money, lower your interest rate and reduce your monthly payment. However, a refinance is not for everyone. Don’t be lured into a bad deal in the long term with the promise of a lower payment today. Shop around and use an online calculator tool to crunch the numbers first.

 

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