Personal Finance

How To Determine If Refinancing Makes Sense

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 15 minute read

There hasn’t been this much heat on inflation for years, so you’re certainly looking for ways to save money everywhere you can. One of the biggest is probably right under your nose if you own your own place. Perhaps you’re currently occupying that very seat.

If the interest rate on your current mortgage is higher than the rate available today, refinancing could lessen your payment and provide you some breathing room financially. 

Refinancing might save you dozens, if not hundreds, of dollars monthly, depending on the size of your outstanding balance and the difference between those two rates. Nevertheless, just because it seems good on paper doesn’t mean you should go ahead and refinance your mortgage.

Is It Time to Refinance My Mortgage?

What this means, in a nutshell, is that it is debatable. Refinancing makes financial sense if you expect to save more money over the term of your new loan than you’ll spend on closing costs and other fees.

However, it’s possible that your new loan won’t be a direct equivalent to the old one. It’s possible that the terms of the new loan will be more favorable than the old ones. The advantages of refinancing must be greater than the costs if this is the case. 

One or more of these advantages could include a shorter payout time, a reduced interest rate, or a cheaper monthly payment. You need to know why you want to refinance your mortgage in the first place before you can decide if it makes financial sense. 

You should also think about how your credit, income, and other circumstances may affect your refinancing prospects and interest rate. While you may be leaning toward saying “yes” to the question of whether you should refinance your mortgage, that decision is still provisional.

Don’t rush to get in touch with the bank just yet. Learn the ins and outs of each desired refinancing outcome, how your own financial situation can affect your refinancing loan approval odds and rate, and whether now is the best time to pursue these goals.

Motives for Refinancing Your Mortgage

It’s important to weigh the benefits and drawbacks of refinancing before you apply. Step one is to learn everything you can about the various refinancing motives.

Reduced Interest Rate

Refinancing a mortgage is frequently done to get a new loan with a better interest rate. When mortgage rates are low, it is easier for some borrowers to qualify for a reduced rate. 

In contrast, if your loan balance is less than 80% of the value of your property and your credit score, income, and debt-to-income ratio have all improved since you bought your home, you may be eligible for a lower interest rate if rates are lower now than they were when you received your mortgage.

Conversely, even if rates drop, you may not be able to qualify for a cheaper rate if you have seen a decline in your income or credit score or have had your debt-to-income ratio rise.

Increasing Your Monthly Payment

Your mortgage debt will go down with each payment you make; it won’t go down as rapidly as you’d like, but every bit helps. If rates have dropped since you took out the loan, refinancing the reduced principal into a new loan for the same term could reduce your payments. 

However, if the goal is to reduce the monthly payment, it is important to consider closing and prepayment expenses before refinancing to a rate less than 1.5% lower than the original mortgage.

You can apply for a longer-term refinance loan if you want to reduce your monthly payment. It’s a more surefire method of reducing payments, regardless of whether or not interest rates have gone down.

If you have a 30-year mortgage and have paid on it for eight years but still have 22 years left on the term, you can extend the time you pay no interest on the loan by refinancing the remaining sum into a new 30-year loan. Unless interest rates have significantly increased, this should result in a cheaper monthly payment.

Nonetheless, there is a price to pay for that. In the long run, you’ll have more money in your retirement account if you take out a longer mortgage and pay more interest on your home purchase.

Shorten Your Loan Term

Refinancing your mortgage into a new loan with a shorter term is another option.

Two potential advantages are:

  • Bringing down the overall cost of property ownership by decreasing the mortgage payment
  • Quickening the rate at which your mortgage is paid off, and your path to ownership free and clear

With a mortgage refinance, you can reduce your payback period from 30 years to 15 years, saving you money.

Since the loan would be on the lender’s books for a shorter period of time, the interest rate will likely be lower than it would be for the longer term (30 years). In turn, that can increase cost savings.

When you finally pay off your mortgage, one of the largest expenses in your monthly budget will disappear the principal and interest. Despite the fact that you will still be responsible for housing-related expenses such as taxes and insurance, as well as possible HOA fees, your monthly housing costs will be far lower.

One major drawback of a shorter loan term is the increased payment required each month. You may not be able to refinance into a shorter loan term if you don’t have enough room in your budget to cover the larger payment without reducing other spending or coming up with a sustainable source of additional income.

Tap Into the Equity in Your Home

With consistent mortgage payments and an increasing or constant house value, homeowners can more easily access their property’s equity as time goes on.

The term “cash-out refinance” refers to a type of mortgage refinancing that allows you to take money out of your home’s equity. You can put the money toward anything from paying off high-interest debt to making some much-needed repairs around the house.

There are a few financial institutions that will offer a borrower up to 85% of their home’s appraised value in a cash-out refinance, but the majority of institutions will only lend up to 80%. 

The following steps will help you estimate how much money you can get from a cash-out refinance:

  1. Use sites like Zillow and Redfin to get a feel for how much your home is worth right now on the open market.
  2. 20% of that figure must be subtracted.
  3. Make sure you deduct the amount you still owe on your first mortgage.

Let’s say the appraised worth of your home is $500,000. You’d have $400,000 after deducting $80,000 (20% of $500,000) to get there.

As an example, if you have $300,000 left on your first mortgage and can borrow up to that amount plus $100,000 more, you will have $400,000 in your hands. A cash-out refinance loan can provide you with up to $100,000.

Get Private Mortgage Insurance Exemption

Private mortgage insurance is a large part of the monthly housing payment that may be eliminated through refinancing. When a borrower puts down less than 20% on a traditional mortgage, private mortgage insurance must be added to the loan. 

Many homeowners choose to wait it out because it disappears automatically whenever the mortgage balance is 78% or less of the home’s current market value.

However, the waiting period will extend over a number of years if you pay less than 20% down. Refinancing can immediately get rid of private mortgage insurance if the value of your house has increased substantially since you purchased it and your loan-to-value ratio is far below 80%.

How to Terminate an FHA Loan

Refinancing an FHA loan, or a loan sponsored by the U.S. Federal Housing Administration makes sense if your credit has improved since you purchased your home for any of the same reasons that would justify a refinancing of a conventional mortgage loan.

One typical justification, however, is the desire to cancel FHA mortgage insurance. Depending on the loan’s length, issuance date, and initial down payment, annual FHA mortgage premiums may reach 1% of the loan principal. The good news is that costs don’t have to mount up immediately.

Once you have reached 20% equity in your house, you can eliminate your annual FHA mortgage insurance payments by refinancing into a conventional loan. For the foreseeable future, you won’t have to pay for mortgage insurance.

Be aware that the 1.75% upfront mortgage insurance premium required for all FHA loans will still be due even if you refinance out of your FHA loan and into a conventional loan. If you included it in the principal of the first loan, it will follow you into the next one.

Change from an adjustable-rate mortgage to a fixed-rate mortgage

At first glance, an ARM appears like great value. The interest rate is locked in at a low level for the first few years (usually five to seven). This rate is typically lower than the rates for 30-year fixed-rate mortgage refinancing.

The first time the rate can be changed is at the conclusion of the original period, thus that’s when the calculation will be made. If interest rates have risen during that time, the rate will reflect that. Following the initial year, it is subject to fluctuation every year in response to market conditions, including interest rate fluctuations.

Although borrowers are protected to some degree by restrictions on rate and payment increases, it can be challenging for household budgets to absorb increases in an adjustable-rate mortgage. Many people with adjustable-rate mortgages switch to fixed-rate loans before the first rate increase.

With the prepayment penalty in mind, this strategy could still significantly cut your borrowing costs during periods of high interest. It also ensures future mortgage payment certainty, which is potentially equally as crucial.

Consolidate Debt

Refinancing with cash out might help you consolidate high-interest loans like credit card bills without breaking the bank. Your cash-out refinance loan’s interest rate will almost certainly be lower than the interest rate on your credit cards.

A cash-out refinance loan can be used to combine the balance of an existing home equity loan or line of credit with the balance of your primary mortgage, so eliminating one monthly payment and perhaps lowering your interest rate.

A Jumbo Loan Can Be Refinanced Into a Conventional Loan

Nonconforming jumbo loans carry a higher degree of risk for lenders because they are not covered by the government-supported home mortgage companies, Fannie Mae and Freddie Mac. They therefore typically have higher interest rates than conventional loans. 

All that conforming means is that the terms meet the criteria set down by Fannie Mae and Freddie Mac. 

If the remaining balance on your jumbo loan is less than the conforming loan maximum of roughly $650,000 and up to 50% higher in expensive real estate regions, refinancing into a conventional loan might dramatically reduce your interest rate and lifetime interest payments.

Regardless of how much of your closing expenses you choose to roll into your new loan, your total financing amount cannot exceed the conforming loan limit.

Don’t Use the Name of a former Spouse or Partner.

The decision to refinance your mortgage in order to remove a former spouse or partner is more motivated by convenience than by a desire to save money.

However, if rates have dropped since you bought your home, doing so can likely cut your monthly mortgage payment and lifetime borrowing costs. Regardless, it’s just another expense associated with splitting up.

Your mortgage lender may allow you to drop your ex-spouse or partner from the loan’s title without requiring a new loan. To do so, a debt assumption or refinancing will be necessary. Both of these options get you where you want to go with your name on the title without the expense or hassle of refinancing.

There are a number of lenders who will not negotiate loan modifications or accept loan assumptions. Consequently, as soon as the ink is dry on the divorce documents, you should refinance your mortgage to remove the name of your ex-spouse or partner from the title.

One potential stumbling block is that your ex’s credit and income, which may have been used to qualify you for the mortgage in the first place, will no longer be available to you. Get a co-signer or sell the house if you think it will be too much trouble.

Reasons to Avoid Refinancing Your Mortgage

Think about the potential drawbacks even if you can identify a reason, or numerous reasons, to refinance. It may not be beneficial to try in some cases.

Probably You Won’t Make Money

What this entails is a refinancing so that the name of a previous spouse or partner can be taken off the title. It could be that you need to pay the price and do it nonetheless.

If, however, you’re only doing the refinancing to save money, it’s not worth it if you won’t be able to do so. Use a mortgage refinancing calculator to determine your anticipated payoff period before submitting an application.

Fill in the details of your refinancing loan to calculate your monthly principal and interest payments. Get a monthly total by adding your mortgage payment, private mortgage insurance, homeowners association dues, and property taxes from your mortgage servicer.

You should deduct from your monthly payment any expenses that don’t pertain to your new loan, such as your annual FHA mortgage insurance fee. From there, you can extrapolate the entire cost of your monthly payments for your refinanced debt.

Then, take that number and deduct it from the amount you’re now spending each month on your mortgage. This is the estimated monthly cost savings after refinancing. The next step is to round up your anticipated monthly savings from your refinance loan and divide that number by the total closing fees.

If you don’t alter the interest rate or any other aspect of your original loan, that’s how long it will take for your refinance loan to pay for itself. 

You will save money in the long term by refinancing if the date of your breakeven point is sooner than the projected repayment date of your original loan or the earliest date on which you plan to sell your house. Staying put in your house for as long as possible can allow you to accumulate substantial savings.

Your Savings Are Very Limited

If you’re already at the point where interest payments equal principal, refinancing may not be worthwhile. The procedure itself is tedious and frustrating.

You should calculate how much money you will save through refinancing before you really do it. It might represent a decrease of $100, $200, or $500 from your regular monthly payment. You alone have the information necessary to solve this puzzle.

The Closing Costs Are Too Expensive for You

A smaller initial sum with a lower interest rate does not necessarily result in a reduced monthly payment. There will always be fees associated with closing on a refinance loan. Refinancing loans often have closing charges between two and five percent of the loan amount. 

That’s a wide range, and unless you qualify for a loan, it’ll be difficult to estimate what your closing fees will be. The final sum will certainly fluctuate even then, though, until the very end.

Even so, you can get a rough estimate of your loan’s total cost by adding up the possible closing expenses before you apply.

  • A possible 1.5% of the loan amount as an origination fee
  • The cost of the evaluation shouldn’t be more than $500.
  • Premiums for title insurance are usually between $400 to $1,000, though they could be less if the policy is altered.
  • A possible settlement cost of $1,000
  • Prepaid interest with a discount, also known as discount points, can lower the interest rate on a loan by 0.25% for every 1% of the loan’s value that is paid upfront.

They can quickly add up to a significant sum. With a refinance, closing expenses are often rolled into the principal balance to raise the amount of the loan that accrues interest. You can end up with a bigger loan if your initial balance wasn’t significantly lower than the balance on your first mortgage.

If your current mortgage is less than five years old, you may be subject to a prepayment penalty of anywhere from three percent to five percent of the loan’s principal balance if you decide to refinance. Those are really popular.

Experts advise caution when refinancing to a rate less than 1.5% lower than the original mortgage if the goal is to reduce the monthly payment, as the combined closing and prepayment expenses might add up to be rather significant.

Check your finances to make sure you can pay the refinancing closing charges and early payment penalty.

You’ll be Moving Soon

A home should not be refinanced if the owner intends to sell it before the loan is paid off. There is no purpose in refinancing if the transaction would result in a loss.

If you want to move but would be better off renting rather than selling your present property, you’ll need to adjust your budget accordingly. Your monthly savings from your refinanced debt will continue for as long as you remain the property’s owner, even if that’s years or decades from now.

Increasing your Credit Score is Necessary.

If your credit score has dropped since you purchased your house, you will no longer be eligible for the most competitive mortgage rates. There go any potential savings from refinancing, though you won’t know for sure until you figure out your new monthly payment.

There is still hope if you find out you won’t be able to save money by refinancing since you don’t qualify for a low-interest rate. If your credit score is low, you should work to raise it, keep a careful eye on it, and be prepared to reapply when it has improved.

Refinancing Your Mortgage: Is It Right for You?

Still debating whether or not a mortgage refinance makes sense? Look at the scenarios when getting a refinance loan would be a good idea, and the ones where it would be best to wait.

Refinancing your mortgage is a good idea if…

Refinancing your mortgage can be beneficial in several ways. For the most part, refinancing is only a good idea if you stand to gain something substantial down the road.

  • Your Regular Payment Can Be Reduced. Refinancing may help you save money each month if you are able to lower your payments.
  • You’re Interested in Accelerating Your Mortgage Payoff. Although refinancing into a shorter-term loan will likely increase your monthly payment, you will save money on interest throughout the loan’s lifetime and will eventually own your property owner. For some reason, you’ve decided to cancel your mortgage insurance. If the value of your property has improved since you purchased it, refinancing could allow you to drop the costly mortgage insurance you’ve been paying on it.
  • As such, you may be interested in refinancing your current FHA loan. You will need to refinance your mortgage if you wish to switch from an FHA loan to a conventional one.
  • You Should Avoid a Rate Increase. You can lessen the financial blow of a rise in interest rates on your adjustable-rate mortgage by switching to a fixed-rate mortgage.
  • Financing at low-interest rates is something you must have. By refinancing your mortgage, you can use the money you’ve built up in your home to accomplish a wide variety of long-term monetary objectives, including but not limited to the consolidation of debt, the completion of a sizable home improvement project, or the repayment of substantial consumer debt.
  • Your Goal Is Not Monetary. It’s not always a good idea to refinance, but sometimes it’s necessary. Ex-spouses who no longer own the home often want to refinance in order to be removed from the loan.

Refinancing May Not Be the Best Option If…

It’s not always a good idea to refinance your mortgage. If any of the following describes your predicament, you may want to reconsider.

  • There will be no financial savings. Refinancing isn’t a good decision if it doesn’t lower your payment or interest cost throughout the life of the loan, regardless of any other goals you may have.
  • The goal is to make a profit before selling. There is always a point at which a refinancing loan becomes profitable. If you plan on selling the house before the refinancing term is over, it is not financially prudent to refinance.
  • Unfortunately, Your Credit Is Poor. It may be impossible to get approved for a refinance loan if your credit score dropped significantly when you first received your mortgage. There is no guarantee that doing so will reduce costs. It’s best to hold off on applying until your credit has improved.

Bottom Line

In general, refinancing your mortgage loan is a good idea if you plan to stay in your house long enough to recoup the costs of the refinancing. Your purpose, such as paying for a sizable home repair job, could help determine whether or not a refinance loan makes sense even if you don’t want to turn a profit.

It is important to know what to expect from a mortgage refinancing before beginning the process. The application process for a loan of this size is not for the faint of heart.

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