Should You Refinance Your Home Loan?
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Refinancing your home involves taking out a new mortgage — usually with better loan terms — and paying off the original loan. Homeowners often refinance to meet a financial goal, like getting a lower interest rate, borrowing cash, or removing mortgage insurance. Let’s explore whether refinancing is right for you.
How does refinancing your home work?
The process is similar to taking out your first mortgage, minus shopping for the home. When you refinance, you’ll apply for a new home loan with a lender. They’ll use the funds to pay down your original home loan. Then you’ll repay the new mortgage — with new terms — over time.
What are different types of home refinancing?
There are two main types of mortgage refinances:
- Rate-and-term refinance: A rate-and-term refinance replaces your mortgage with a new home loan with an updated interest rate and/or repayment timeline.
- Cash-out refinance: A cash-out refinance allows you to take out a mortgage for more than you owe, pay down the original loan, and keep the difference in cash. You can use the funds for any purpose.
You can choose either one based on your financial goals and what you qualify for.
5 scenarios where refinancing your mortgage might benefit you
Refinancing could benefit you in certain situations. Consider this move if you want to:
1. Change your loan term
When you refinance, you can choose a new loan term. Extending the term can help lower your monthly mortgage payments, which might benefit you if your budget is tight. Just keep in mind you could wind up paying more interest if you go this route.
The other option is refinancing to a shorter term to save money in the long run. If you started with a 30-year loan and refinanced into a 15-year loan, for instance, your monthly payments would increase. But you would also pay less in interest overall.
But if you refinance your loan to a shorter term of 15 years, you’ll save $63,004 in total interest, though your monthly payment will increase by $261.
2. Lower your interest rate
Homeowners typically refinance when they qualify for a lower interest rate. This can help lower your monthly mortgage payment and the amount of interest you pay over time, as long as you’re not increasing the loan term. You may qualify for a better refinance rate if market rates are dropping or your credit score improved since you took out the original loan.
3. Switch to a fixed rate
Some borrowers have an adjustable-rate mortgage, or ARM, where the interest rate is fixed for a certain time frame and then can change regularly. For instance, a 7/1 ARM has a fixed interest rate for seven years and then may change once a year for the rest of the loan term.
If your fixed-rate period is over soon and you think your rate will adjust upward, you may decide to refinance into a fixed-rate mortgage. This will provide predictable mortgage payments going forward.
4. Get cash out
A cash-out refinance allows you to borrow money when you refinance your mortgage. Because you can use the funds for any purchase, this could be a good option if you have other financial goals, like debt consolidation or home improvements. You’ll typically need a loan-to-value ratio — your mortgage balance divided by your home’s market value, expressed as a percentage — lower than 80%. So, before going with this option, you’ll need to first build enough equity to borrow from it.
5. Remove mortgage insurance
Mortgage insurance is a type of policy that protects the lender in case you default on your home loan. Mortgages backed by the Federal Housing Administration (FHA) and the Department of Agriculture (USDA) require mortgage insurance throughout the life of the loan in some cases. Conventional loans require private mortgage insurance if your down payment is less than 20%.
But you can cancel mortgage insurance on a conventional loan once your loan-to-value ratio reaches 80%. So if you qualify to refinance an FHA loan or USDA loan into a conventional loan, you may eventually drop mortgage insurance and save money.
Check Out: When to Refinance a Mortgage: Is Now a Good Time?
2 scenarios where you might hold off on refinancing your mortgage
Refinancing your home can provide a lot of benefits, but it’s not always the best financial move. Here are two scenarios in which refinancing might not make sense.
1. Your break-even point is too far in the future
Lenders typically charge closing costs to refinance a home loan. These average around $5,000, but they’re influenced by the size of the loan and where you live. Your break-even point occurs when your monthly savings from the refinance offset the costs of taking out the new loan. Not everyone’s break-even point comes at the same time, so you’ll need to figure it out for your own situation.
5,000 ÷ 100 = 50
In this example, it will take you 50 months — just over four years — to reach your break-even point. Depending on how long you plan to stay in your home, consider whether this is acceptable to you.
2. The long-term costs are too high
Refinancing won’t always save you money. For instance, reducing your interest rate but refinancing into a new 30-year term restarts the amortization schedule. Because most of your interest charges occur in the early years of a home loan, you may wind up paying more interest than if you hadn’t refinanced.
Some homeowners still choose to extend their loan term if they need to lower their monthly payments. You may decide to do this if you’re having trouble affording the mortgage. Once you’re back on strong financial footing, you can pay more toward the principal each month to save on interest costs.
Learn More: The Cost to Refinance a Mortgage (and How to Pay Less)
5 steps to refinance your home loan
When you’re ready to refinance, here are the steps you can expect to take.
- Figure out why you want to refinance. You should have a clear reason for refinancing — and make sure you have a good shot at meeting that goal.
- Get quotes from multiple lenders. Mortgage rates change all the time, and every lender has a different way of setting loan terms and closing costs. Getting quotes from at least three lenders can help you see what you might qualify for.
- Prepare your application and supporting documents. Once you choose your lender, fill out the refinance application and prepare your documents. You may need to provide copies of your recent tax returns, pay stubs, and homeowners insurance policy. The lender will also order an appraisal to determine your home’s market value.
- Go through underwriting. Your lender may ask questions and request more documents during this stage. Follow up quickly so you’re not slowing down the process. It’s also important to maintain strong credit, so don’t take out new loans or rack up a high credit card balance before closing on your refinance.
- Close on the loan. Bring a cashier’s check to cover your closing fees, if you have any, and be prepared to read and sign the loan documents. Once you close on the refinance loan, you’ll make payments to the lender over the course of your loan term.
Frequently asked questions
Here are some frequently asked questions about refinancing your mortgage.
When is the best time to refinance your home loan?
Homeowners usually refinance when they qualify for a lower interest rate. This can save you money over time — as long as you’re not extending the loan term by much — and free up your cash flow each month. Another good time to refinance might be when your adjustable-rate mortgage is about to adjust upward. Refinancing into a fixed-rate mortgage provides the security of predictable payments.
How do you determine whether it’s right to refinance?
If your credit score has improved since you first took out a home loan, you may qualify for a lower interest rate that helps you save money. You may also be able to get better terms if interest rates in the market are dropping. In both cases, it’s a good idea to calculate your break-even point, which happens when you recoup the costs of refinancing.
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See Also: Loan Modification vs. Refinance: How to Decide
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