Mortgages represent the largest component of household debt in America. This makes mortgage refinance one of the biggest opportunities for reducing debt and interest payments.
Before you select a new loan, shop around for the best rates, and calculate your break-even point. Mortgage rates have fallen to record lows, leading to a refinancing boom. However, you still need to determine the point at which you gain back the costs from the refinance and start saving money.
When you refinance your home mortgage, you’re swapping your current home loan with a new one that offers you a new (hopefully better) interest rate. You may also adjust the term of the mortgage refinance loan. So if you’ve paid five years on a 30-year loan, refinancing may mean starting with a new 30-year mortgage again. However, refinancing also gives you the opportunity to shorten your term.
Reasons you might want to refinance your mortgage
If you’re scratching your head and wondering why you would want to refinance, know there are several of reasons, including:
- Secure a lower interest rate.
- Change from an adjustable-rate to a fixed-rate loan.
- Reduce your monthly payments.
- Consolidate your debts.
- Remove someone from the loan.
Keep in mind it’s not always necessary to refinance. An alternative solution – depending on your goal – might be to obtain a home equity loan or a home equity line of credit.
Pros and cons of refinancing your mortgage
Keep in mind, refinancing your mortgage has many pros and cons. Examine each factor as it relates to your specific situation to figure out if refinancing is the right move for you.
Here is a list of the benefits and the drawbacks to consider when refinancing your mortgage.
- Lower interest rate.
- Lower your monthly payments.
- Convert an adjustable-rate mortgage to a fixed-rate
- Remove someone from the loan.
- Borrow against your home’s equity.
- Extending your loan term could cost you more money.
- Could be denied if your credit or income has dropped.
- High fees and costs.
Types of mortgage refinancing
Now that you understand the pros and cons of refinancing, here are the types of refinancing loans you’re offered.
15-year loans and 30-year loans
A loan scheduled to be paid off in monthly payments over 15 years or 30 years. You can usually get a better interest rate on a 15-year loan, but the payments are generally higher.
Fixed versus variable
Fixed-rate loans mean that the interest rate stays the same for the length of the loan (usually 15 or 30 years). Variable rate loans mean the interest rate goes up or down based on the prime interest rate at any time. Variable rates are usually much lower than fixed rates when interest rates are low. But, these interest rates skyrocket when the prime rate goes up, causing your payments to soar, too.
A cash-out refinance is a loan to refinance your mortgage and get a lump-sum of cash by using the equity in your home as security. Home equity is the difference between the value of your property and the amount you owe on it. So if your property is worth $400,000 and you owe $250,000 on your mortgage, you would have $150,000 in equity.
When you have equity, you can refinance your mortgage and take out a loan that is greater than the amount you owe on your existing mortgage.
A cash-in refinance is a mortgage refinance that requires you to pay down your existing mortgage to under a certain loan-to-value ratio to qualify. Loan-to-value is calculated by taking your mortgage divided by the value of your property. For example, many lenders will not consider refinancing a mortgage with a LTV higher than 80%.
This option requires you to pay closing costs out of pocket. It is usually done to fix an “upside-down loan”, to get out of paying mortgage insurance, or to avoid the rising interest rates of an existing variable-rate mortgage. (Upside-down loans, or “under water” mortgages, are when you owe more on the house than its current market value.)
The Federal Home Affordable Refinance Program, or HARP for short, has ended. However, there are HARP alternatives offered by Fannie Mae and Freddie Mac. There are also state government programs to help homeowners avoid foreclosure, as well as finance programs for veterans. Speak to your mortgage lender about any government refinancing programs you may qualify for.
Rate-and-term refinancing pays off your current mortgage and issues a new loan. Most refinancing options are rate-and-term refinancing.
A short refinance helps homeowners avoid foreclosure. The mortgage lender will pay off the current mortgage and replace it with a loan with a lower balance.
Refinance options to repay high-interest debt
If you have a large amount of debt, refinancing your mortgage can save you money. Here are several alternative refinancing options to help you manage your debt.
Consider a cash-out refinance
If you qualify for a mortgage refinance, consider a cash-out refinance to consolidate and pay off your other debts.
A cash-out refinance involves getting a new loan with a lower interest rate for a larger amount than the existing mortgage loan. As the borrower, you receive the difference between the two loans in cash to use as you please.
In this case, you’ll be using the cash to pay off your high-interest debt like credit cards, a car loan, or a personal loan.
With this strategy, you can consolidate debt into a home loan and pay it off at a much lower interest rate.
Borrow against the equity in your home
Another option would be to get a home equity loan or line of credit to pay off debt.
A home equity loan allows you to use your home equity as collateral to borrow a fixed amount of money. You’ll receive the money upfront, which you then have to make payments on (usually over a period of-of 15 or 30 years, for example). The amount of equity in your home will determine how much you qualify for, as will your payment term, income, and credit history.
A home equity line of credit (HELOC) allows you to borrow against the equity in your home for a fixed period. It’s a revolving line of credit (usually a percentage of your home’s equity) that allows you to access money when you need it. Similar to a credit card, you can borrow what you need, pay off the balance, and then borrow again.
Remember, the amount of equity you have in your home equals the market value of your home, minus what you owe. Using our example above, let’s say you have $100,000 in equity and would like to borrow some of that value to pay off your high-interest debt.
You can apply for a HELOC and be given a period where you can withdraw the funds you need on an ongoing basis, just like with a credit card. The only difference is that you’re not required to make payments immediately. You can pay back the funds you borrowed after the draw period ends.
How much will it cost to refinance my mortgage?
Many homeowners would like to refinance but may worry about the closing costs. Refinancing isn’t free, but it might not be as expensive as you believe, and there’s an easy way to avoid most of the costs. Either way, refinancing can be smart if you have a good reason to do it and expect to benefit from it.
The costs you’ll usually have to pay fall into two buckets:
Origination fees charged by your lender
Lenders charge a variety of loan origination fees, which vary by state. These include origination fees, originator fees, points, commitment fees, document preparation fees, lender fees, processing fees, and underwriting fees. The table below shows a range of typical fees, but lenders don’t usually charge all of these fees. More likely, you’ll see a wide range of fees from different lenders.
Although these fees have different names, they can be the same. These fees are the amounts the lender charges you for underwriting, processing, and originating your new loan.
Some origination fees are based on a percentage of your loan amount while others are flat fees. Fees that defined as “points” are percentage-based. One point equals 1% of the loan amount.
Examples of third-party fees include appraisal fees, attorney fees, and closing fees. Some lenders break it down further into settlement fees, credit report fees, survey fees, flood certification fees, title search, title insurance, and recording fees. Fees vary depending on the lender and their service providers. The table below shows a range of the fees you can expect to pay. Again, lenders don’t usually charge all of these fees. More likely, you’ll see a wide range of fees from different lenders.
Third-party mortgage refinancing fees vary by state. The differences between states are much larger for third-party fees than origination fees. The average in 2017 was around $1,133.
Do you qualify for mortgage loan refinancing?
Homeowners can pay closing costs out of pocket, or they can usually have the mortgage lender roll those costs into the new loan.
Just like when you closed on your current mortgage, the refinancing process ends with closing, and that costs money. There are two ways to handle closing costs: pay it out-of-pocket or have the costs financed into the new loan.
In cases where getting your cash equity is the reason for refinancing, you’ll probably want to finance the closing costs into the new loan to keep as much cash as possible on hand. But if you are trying to get the loan payments reduced or get the home paid off faster, it’s a good idea to pay closing costs out of pocket, if possible.
What is the ‘break-even point’ for mortgage refinancing?
The break-even point is the point at which the borrower recoups the cost of refinancing through the savings. For example, say you refinanced your mortgage and the closing costs were $6,000. After refinancing, you save $300 per month on your payments. It will take you 20 months to reach your break-even point:
$6,000 ÷ 300 = 20
Unless you’re keeping the house for at least two more years, it wouldn’t make sense to refinance. Only refinance your home loan when you plan to stay long enough to pass your break-even point and begin saving money.
How to compare mortgage refinancing lenders
Just like shopping for your first home, it pays to shop lenders and look into refinancing options. Some lenders have lower interest rates or more flexible loan terms. Others may offer great deals on closing costs or have less strict guidelines for loan qualification. Just be sure to do the math. If a lender is willing to work with you on a lower credit score, they may charge more interest. In this case, you might not save enough on refinancing to make it worthwhile. Make sure the math makes sense before agreeing to a refinancing loan.
Remember, interest rates fluctuate on a daily basis. As soon as you get a good loan rate negotiated with your lender, get it in writing so that it’s locked in. That way, if mortgage rates happen to go up in the next few days or weeks, you won’t be stuck paying the higher rate.