Learn how to refinance and lower your mortgage rates with this easy to follow guide.
Mortgages make up the vast majority of debt that American households carry. The Federal Reserve reports that Americans owe $8.36 trillion on mortgage loans. Of that number, $427 billion represent new mortgage balances, which include both first-time mortgage loans and mortgage refinances.
Mortgage refinancing is a popular strategy for improving your financial situation. Are you exploring your options for refinancing? If so, keep reading.
What are some reasons to refinance your mortgage?
Although there are good reaons to refinance your mortgage, it’s not always a smart move.
These are the most common reasons for refinancing:
- Lowering your current interest rate.
- Shortening the term of your mortgage.
- Converting from an adjustable-rate mortgage to a fixed-rate mortgage, or vice versa.
- Using home equity to finance a large purchase.
Let’s take them one at a time and examine whether they make sense.
Lowering your interest rate
One of the best reasons to refinance a mortgage is to lower your interest rate. Even a drop in your interest rate of 1 or 2 percent often makes refinancing a financially sound strategy. Why?
Reducing your interest rate leaves more money in your wallet by reducing your monthly payment. At the same time, it helps you build equity in your home more quickly, which is always a good thing. There are many free online mortgage calculators that you can use to help you find out exactly how much you can save by refinancing your mortgage with a lower interest rate.
Shortening the term of your mortgage
Shortening the term of your mortgage loan may not save you money upfront, but in the long run, you can save thousands of dollars in interest. For example, suppose that you owe $200,000 on your home and your current mortgage is a 30-year loan at an interest rate of 7.0 percent. Your monthly payments, not including property taxes and home insurance, would $1331 per month. Over the life of your loan, you will pay $479,018.
However, if you refinance your home choosing a 15-year term and an interest rate of 3.5 percent, your monthly payments would be $1430. You would save $99 a month and $221,802 over the life of the loan. And you would pay off your mortgage in half the time!
Converting from an adjustable-rate loan to a fixed-rate loan
Refinancing to change your interest rate from an adjustable rate to a fixed rate (or vice versa) may or may not be a sound financial decision. It is important to crunch the numbers to see if this is a sound strategy.
For example, if your adjustable rate is constantly adjusting upwards, it is possible that locking in a fixed-rate is the wise course. However, if your adjustable rate is considerably less than the best fixed rate you can find, you may want to ride out the adjustments and continue to take advantage of the lower rate.
Another factor to consider is how long you intend to stay in your home. If you plan to move within a few years, an adjustable-rate mortgage may be your best option because adjustable rates usually start out considerably lower than fixed rates. On the other hand, if you plan to stay in your home for a long time, a fixed-rate mortgage may offer you the best savings over time.
Using home equity to finance a major purchase or consolidate debt
This is another gray area. Whether refinancing to take advantage of the equity you have built in your home is a sound financial strategy depends on several variables. If you can find a low interest rate, you may decide this is a reasonable option.
Using a mortgage loan to consolidate debt may be a slippery slope. Since the type of debt you want to consolidate may be unsecured debt, you must weigh whether you want to put up your home as collateral to pay off debt.
What are the major types of refinances?
The two major categories of refinance loans are regular refinancing (also known as rate-and-term refinancing) and cash-out refinancing. Under these two broad categories, there are several sub-categories.
Regular refinancing is the most common type of refinancing. It is done with the purpose of lowering your interest rate or changing the term of your mortgage.
Cash-out refinancing is just as it sounds. With a cash-out refinance, you can borrow money and refinance your mortgage at the same time. You do this by borrowing against the home equity you have accumulated.
Another type of loan is HARP loans, which are a special type of refinance for homeowners with Fannie Mae- or Freddie Mac-backed mortgages with low or negative equity. A HARP loan allows you to refinance without an assessment of the home’s current value.
If you have an FHA or VA loan, a streamline refinance is an option that allows you to refinance to current market rates if your mortgage payments are current. The advantage of this type of refinance loan is that there is no need to verify credit, income, debts or the value of the home.
What are some costs associated with refinancing?
As is the case with any major financial decision, it is wise to sit down and calculate the cost of refinancing before you dive in. Just as there were costs associated with getting your existing mortgage loan, there are costs related to refinancing your loan. It is not unusual to pay 3 percent to 6 percent of your outstanding principal in refinancing fees. Typical costs include:
- Lender application fee.
- Title search and title insurance fee.
- Lender attorney review and closing fees.
- Underwriting fees.
- Loan origination points and fees.
- Appraisal and inspection fees, if required by your lender.
Estimates for these costs should be included when you consider whether refinancing your home is right for you.
What is a break-even point, and how is it calculated?
If you are not sure whether refinancing is a good idea or a bad one, one of the things you need to figure out is your break-even point. Your break-even point is the time it will take for your mortgage refinance to pay for itself.
You can figure this out by dividing your total closing costs by the monthly savings you will get from refinancing your loan. For instance, suppose your total closing costs for refinancing your loan are $5,000. Then suppose your new loan payment will be $200 less each month than what you are paying now. If you use the formula above, your break-even point will be 25 months.
Why does that matter? The break-even point matters because it is the point at which you will begin to reap the advantages of refinancing. In the illustration above, it will take you 25 months before your refinance saves you any money. If you are planning to stay in your home longer than 25 months, refinancing is a good idea. If, however, you are planning to move in the next two years, refinancing may be a poor choice.
What are the pros and cons of cash-out refinances?
Regular refinancing to get a better interest rate and better terms may be a no-brainer, but cash-out refinancing is a little trickier. It is important to be aware of the pros and cons of this financial strategy.
- A lower interest rate or lesser loan term than you currently have.
- A lower payment than you are currently making.
- The ability to consolidate high interest rate unsecured debt.
- Mortgage interest may be tax deductible.
- Potentially jeopardizing your home by using it as collateral to consolidate previously unsecured debt.
- Potential for paying much more interest over the term of the loan than you might have paid by pursuing another method of debt consolidation.
- Fees associated with refinancing.
- Potential prepayment penalty for your current mortgage loan.
If you need help weighing your refinancing options, you can ask your lender or mortgage company to assist you.
How can you find a good mortgage company?
A good mortgage company will work with you to find the best refinance option for your particular situation. Such a company will crunch the numbers for you, explaining how variations in your interest rates or terms will affect you both now and over the course of the entire loan. Do not be afraid to ask questions about every part of the process to ensure that you are doing what is right for you. When you are ready to explore your options, find the best mortgage companies here.