Some people refinance their mortgage loan in order to have a lower monthly payment. Others do it for cash back in order to pay for a home renovation. Everyone has their own reasons for wanting to refinance their home loan, but the truth is that refinancing a home loan is not for everyone. It’s important to look at the risks and the benefits, and decide if the costs associated with refinancing, such as closing costs and credit checks, outweigh the benefits. If they do, it’s important to wait to refinance until the time is right.
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Know Your Break-Even Point
Your break-even point will decide whether or not refinancing is a good idea for your long-term financial health. This point is when you will save an amount equal to the costs of refinancing — in other words, when the refi pays for itself. Calculate your break-even point by taking the total closing costs of the refinance and dividing it by your monthly savings. For example, if your closing costs for refinancing are $2,000 and you’ll save $100 each month by refinancing, your break even point would be 20 months. If you aren’t going to be in your home long enough to reach your break even point, you should consider skipping a refinance.
Lower Interest Rate
If you can get an interest rate that is lower than your current rate, it is worth looking into refinancing. However, the break-even point still applies. Even a rate that is 1% lower than your current rate can be worth the refinance long-term — if the term is long enough for you to realize savings. Not only will this help you to save money each month, it also helps you to gain home equity faster. If your credit score has gone up since you took out your home loan, you may now be eligible for a lower rate.
However, everything that goes into a mortgage refinance is a process. It’s not an overnight deal, and there are closing costs in a refinance just like there are when closing on your home initially. For that reason, weighing the costs and benefits is paramount.
Shorter Loan Term
Some people refinance and change the loan term in order to reap the associated benefits. Generally, refinancing for a longer term will give you a smaller monthly mortgage payment. However, it’s important to look at the long-term benefits as well as the short-term ones. If you refinance for a shorter term, it may raise your payment, but you could get a better interest rate and set you up to pay the loan off sooner. However, a shorter term loan might not be as ideal if you’re not planning on being in your home long-term.
However, if you want a shorter term loan, your debt-to-income ratio must be low. This ensures that a lender knows you can afford the higher monthly payment. Many lenders recommend you don’t get a shorter term loan due to the many unknowns in life that can make paying a higher mortgage difficult, such as job loss or health emergencies, and suggest extra money towards retirement may be more beneficial. However, you and your lender can discuss those financial intricacies in more detail.
Converting an Adjustable-Rate Mortgage to a Fixed Rate
An adjustable-rate mortgage (ARM) has more risk than a fixed rate mortgage. While ARMs tend to start out at a lower rate, making them tempting for buyers, adjustments can result in rate increases that can become higher than a fixed rate option. For short-term buyers who take the risk on a lower interest ARM, they might take the gamble hoping that the rates wont adjust above the fixed rate option while they own the home. Though the uncertainty makes it questionable, if the market is in a period of falling interest, it may be a sound strategy.
For those who took the ARM gamble and found that the adjustments were higher than a fixed rate option, refinancing is an option in order to take a fixed rate instead. Just be aware that having an underwater mortgage can make refinancing nearly impossible. An underwater mortgage is a loan with a higher investment than the home’s value. If the homeowner doesn’t have any equity available for credit as a result, it can potentially prevent a borrower from refinancing unless they have cash to pay the loss out of pocket.
Converting an FHA Loan to a Conventional Mortgage/Eliminating PMI
An FHA loan is a loan with the Federal Housing Administration and is great for a first time homeowners first mortgage. FHA loans make it easier to obtain financing by requiring minimal down payments for fair credit scores. As a result, FHA loans tend to come with private mortgage insurance (PMI) which can be expensive for homebuyers. As a homeowner owns their home and makes their mortgage payments, credit scores increase and home value rises. This provides more equity to homeowners. PMI payments, however, do not contribute toward your equity — they are an absolute expense. Refinancing to a conventional mortgage that will eliminate the costly PMI payments and potentially enable you to pay more each month to gain equity faster.
The downside to converting your mortgage from an FHA loan to a conventional mortgage requires a certain amount of equity up-front. You must have owned your home for long enough to have accrued around 20% equity, either by making enough mortgage payments or through market appreciation. For exact requirements and refinancing costs, it’s important to speak to your lender.
Cash-Out Refinancing
Cash-out refinancing is the process of refinancing your old loan for a new, larger loan and taking the difference in cash. It’s an option available to VA cash-out refinancing for veterans as well. Just know that the cash isn’t free; it’s a loan that uses your home equity as collateral. Whether that cash is to pay down debt or to pay for an upgrade that may help the resale value of your home, it’s important to note the positives and negatives associated with this type of refinancing option.
On the positive side, you’ll have extra cash to pay down debt causing issues with high interest rates or credit. You may even help your home gain value if you use the cash to upgrade your home. On the down side, if you’re using it to pay debt, you’re just moving your debt from one place to another. When you sell, you wont get as much because of the larger loan to pay. If the market declines, you could be in even more trouble owing the bank more money as your house falls into negative equity.
The benefits of refinancing your home and deciding when to refinance often go hand in hand. Lowering your payments and getting the most out of your home investment involves looking into refinancing in order to lower your interest rates, possibly lowering the total cost of your home long-term, keeping a consistent interest rate, removing mortgage insurance, or getting cash from your equity. However, knowing when to do this involves calculating your break-even point. Refinancing isn’t free, so making the right decision involves understanding how much equity you’ve gained into your home and how long you plan on staying there.
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