FHA loans are a wonderful tool, especially for first-time homeowners. However, over the course of a 15 or 30-year loan, there may come a time when an FHA loan is no longer the best tool for the job. Knowing when to refinance out of an FHA loan can save you money for the remaining time your house is mortgaged.
When to Refinance Out of an FHA Loan
To help finance the federal guarantee of FHA loans, homeowners are required to pay Private Mortgage Insurance (PMI) both upfront and with their ongoing loan payments. Refinancing out of an FHA loan can be a way of avoiding remaining PMI payments. So, it is important to know when you might qualify for a non-FHA loan that might be cheaper. Here are three possible indicators:
- When you have built up more than 20 percent equity in your home. Lenders are much more accepting of loan-to-value ratios that are under 80 percent, so when you reach that threshold you are more likely to qualify for a loan without PMI. A lower loan-to-value ratio might also qualify you for a better interest rate.
- When you have established a more solid credit history. You need decent credit for an FHA loan, but their federal backing can help you qualify for an FHA loan with a more limited credit history than you would need for other types of loans. As time goes by though, and assuming you maintain a good payment record for your mortgage and other debts, your credit history should become substantial enough to broaden out your mortgage possibilities.
- When you are in position to switch to a shorter loan. By the time you build up 20 percent in equity and establish a more substantial credit history, mortgage rates may no longer be favorable enough to justify financing. However, if those conditions are in place and you can afford to switch from a 30-year to a 15-year loan, the lower interest rate that typically goes with a shorter loan might allow you to lower your rate enough to justify refinancing, and thereby eliminate PMI payments by switching out of an FHA loan.
Tips for Lowering Your Mortgage Expense
Here are some things that can help you spot favorable opportunities to refinance out of an FHA mortgage:
- Familiarize yourself with your amortization schedule. This is the schedule that shows the principal and income components of all your mortgage payments over the life of the loan, so you can see how long it will take to pay down 20 percent of your loan. That will give you a rough idea of when it might be time to start looking at non-FHA refinancing.
- Follow local housing prices. Paying down principal is not the only thing that determines equity; the changing value of your home can add to or subtract from equity. If prices in your area are doing well, you might get to the 20 percent equity threshold ahead of when your amortization schedule indicated you would.
- Know your credit score. Getting a good deal on an non-FHA mortgage may well depend on the strength of your credit score, so monitor this regularly and address any problems immediately.
- Keep an eye on mortgage rates. PMI is generally small compared to mortgage rates, so it is important to recognize that rising mortgage rates could wipe out any potential advantage of refinancing out of an FHA loan. Remember, though, to follow both 15-year and 30-year mortgage rates, because those lower shorter rates might give you the right opportunity to refinance, especially if you are several years into your mortgage.
- Compare lenders before committing. Just because you may be in line to save money by eliminating PMI does not mean you should ignore other money-saving opportunities when you refinance. Comparing lenders to get the best mortgage rate can add to the benefit of eliminating PMI.
- Don't forget about closing costs. Remember, any potential saving on PMI and interest rates must be large enough to offset any closing costs you will incur by refinancing, and do so over the likely time you will continue to be paying your mortgage.
PMI isn't a bad thing – it is part of what makes FHA loans work. However, it is an extra expense, and one that might not be necessary for the entire time you will have a mortgage.