Housing is typically the largest expense in any budget so homeowners should always be looking for ways to reduce debt, build equity, save money, and reduce or eliminate their mortgage payment. Your housing expense consists of up to five factors and refinancing will impact one of the most expensive factors, your mortgage payment.
The fixed expenses associated with homeownership are:
- Mortgage payment
- Property taxes
- Homeowners Insurance
- HOA fee (if you own a home in a building or community)
- Mortgage insurance (if you didn’t put down at least 20% for the down payment)
When you refinance, you are tackling just the first bullet here. Refinancing your home has everything to do with the interest rate today compared to the interest rate your current loan is paying. In a falling interest rate environment, much like what we’ve seen over the last nearly decade, many homeowners are more likely to consider refinancing their mortgage.
When you refinance your home you are paying off your existing mortgage and replacing it with a new one. Experts generally recommend that you should consider refinancing if you are able to secure a rate at least 1% lower than your current rate. The reason you want to make sure there is a big enough change in the interest rate is that a refinance doesn’t come without fees. Remember those pesky closing costs that were roughly 1-3% the value of your home? Those come back! We’ll talk more about that later in the article.
Is this right for me?
Here are some of the reasons you might consider refinancing:
You want to reduce your monthly payment
If you find yourself in a situation where you are having difficulty making your payment while meeting your other spending needs or debt obligations, refinancing may give you the opportunity to reduce your monthly payment. These savings could come in two ways. First, if you are able to secure a lower interest rate than your current mortgage, your payment will be lower. In addition to that, you will be able to extend your current mortgage balance over a new loan term. For example, let’s say you have had your current mortgage for 6 years and during that time have reduced your loan balance by $10,000. If you took out a 30-year mortgage originally, you now have 24 years left. A new mortgage will put that term back out to 30 years with a lower balance, further reducing your monthly payments.
You want to pay off your home more quickly
Perhaps you have decided that you would like to be mortgage-free sooner rather than later. Refinancing your mortgage can help you get there. Due to a lower rate, more of your payment goes to the principal instead of interest and could reduce the time until your mortgage is paid off. Many use this opportunity to reduce the term from a 30-year mortgage to a 15-year mortgage with only a small increase to their monthly payment.
You want to access your equity without selling your home
Refinancing your mortgage can provide the opportunity to access the equity in your home through the use of a cash-out refinance. You may need to access the equity in your home for a variety of reasons. For example, you may have a fair amount of high-interest debt (credit card debt, personal loan, etc.). You may have experienced a financial hardship like the loss of a job or incurred a significant medical expense. Maybe you need the cash to make important home improvements or help pay for your children’s education expenses. While these can be good reasons to use the equity in your home, you will also want to be careful not to use this money to purchase depreciating assets (like a car) or increase your spending.
Remove the requirement to pay private mortgage insurance
When you buy a home there may have been an option to put less than 20% down, even zero. In those cases the lender will almost always require that you purchase mortgage insurance in addition to homeowners insurance. This added expense can make it harder to maintain your overall payments. If you have acquired over 20% in equity in your home you may be able to refinance and remove the need for this additional expense.
Consolidation of a first and second mortgage
When you purchased your home you may have needed to have a first and possibly a second mortgage. At inception, a second mortgage could help you get to the 20% down avoiding the private insurance. This only makes sense, however, if the second mortgage is cheaper than the insurance. You may also have taken out a second mortgage to cover the costs of renovations or home improvements. Often, second mortgages have higher interest rates or shorter repayment terms (20 vs. 30 years) making the monthly payments higher than your primary mortgage. Refinancing may provide you with the opportunity to consolidate these loans into one loan at a lower interest rate - reducing complexity and saving you money.
What about the fees?
While all of these options are good reasons to move forward with a refinance you need to know that there are costs associated with refinancing. Closing costs, including title and appraisal fees, can range between 2-5% of the amount that you borrow. It can take years to recoup that cost with the savings generated by a lower interest rate. So, if you are only planning to stay in the home for a few years or less, the cost of refinancing may negate any of the potential savings. Ideally, you should be able to cover the closing costs through lower payments in 5 years or less. A good way to see how long it will take to recoup the closing costs and ultimately surpass them such that it is a good idea to refinance, is to take the closing costs and divide by monthly savings.
In the above example, you would not want to sell your home before or even shortly after your break even of 12.5 months and 35 months, respectively.
How to prepare for a refinance
While refinancing your mortgage may save you thousands of dollars over the life of your mortgage the process can be time-consuming. To make the process as simple as possible there are some things you can do ahead of applying for the refinance. First, make sure to gather all of your financial documents. This includes recent tax returns, pay stubs, and account statements. Next, you should check your credit score and credit report for any inaccuracies and get an idea of what your rate might be. Last, get an approximate idea of the value of your home by using online tools or looking at other homes that are similar to yours in your neighborhood. Once you’ve done this, make sure to shop around for a lender. Start with your current lender but make sure to find another offer to try to bring down the rate.
In general, there can be great value to refinancing your home if you need the cash or can lower your payments but it's important to evaluate if it's right for your situation first.
If you have any questions about refinancing or might want to consider it yourself, please reach out to your Origin Planner.