Summary
- Mortgage refinancing replaces your existing mortgage with a new one.
- By refinancing, you can reduce your rates, change loan terms, lower monthly payments, or even change the type of loan.
- You should look at your debt-to-income ratio, the equity you have in your home, and loan portfolio when considering refinancing.
- Our mortgage calculator can help you compare the costs of your current mortgage with a refinanced loan.
What Is Mortgage Refinancing?
Refinancing a home can be a great option to reduce your monthly payments, interest rates, or mortgage insurance costs. As home prices have increased, home equity has also risen. This increase in equity (your home’s current market value minus what you still owe on your mortgage) has made refinancing attractive to many homeowners. Refinancing replaces your existing mortgage with a new one with a new monthly payment. Factors such as your home value, finances, credit score, and lender will determine your mortgage monthly payment after refinancing.
How Does Mortgage Refinancing Work?
Refinancing pays off one debt while simultaneously creating another. In the case of home refinancing, you would take out a new mortgage to pay off the original. The terms, length, and amount you owe on your new home loan may be different, but you will still be required to make monthly payments.
Why Consider Refinancing?
There are several reasons people choose to refinance their homes. They might want to extend or shorten their term, lower their payments, use the equity for home improvements, consolidate credit card debt, or simply lower their interest rate. Below we’ll discuss some of the most common reasons homeowners refinance and how they may apply to you.
Reduce Your Interest Rates
Over a 15-year or 30-year period, interest rates can change dramatically. Mortgage interest rates are determined by the Federal Reserve and your credit score. If you originally took out a mortgage with sub-optimal credit or the federal reserve lowers interest rates, you may be able to secure a lower interest rate by refinancing. Securing a lower interest rate can help you save money over the life of your loan and lower your monthly payments.
Take Cash Out of Your Home
If you owe less money than your home is worth, then you may be eligible for a cash-out refinance. This type of loan allows you to borrow against your equity and then use that extra cash for home repairs, major expenses, or other financial needs such as consolidating debt.
Extend or Shorten Your Loan Terms
Often, people may want to change the length of their mortgage when they refinance. Each repayment schedule has its pros and cons. For example, shorter terms will result in higher monthly payments but save money on interest long-term. On the other hand, extending payments may help reduce monthly payments but cost more money over the life of your loan.
Lower Your Monthly Payments
In addition to changing your loan terms, there are other ways in which refinancing may lower your monthly payments. You may enjoy a lower interest rate or you could potentially eliminate a monthly insurance installment. Either way, exactly how much you can save each month by refinancing will vary according to your situation. Speak with your lender to decide whether or not refinancing is right for you.
Avoid Looming Balloon Payments
Generally, a balloon mortgage has lower interest rates and a smaller monthly payment. At the end of the loan term—which is typically five to seven years—you are required to repay the remaining balance in one lump sum. If you have a balloon mortgage that is coming to a close and do not know how to pay the lump sum, refinancing can help. Refinancing to a conventional fixed-rate mortgage can lengthen the loan term, eliminate the balloon payment, and help you and your family keep your home.
Eliminate Private Mortgage Insurance (PMI)
PMI could be adding hundreds of dollars to your mortgage payment every month. If you owe less than 80% of your home's value, then refinancing could help you eliminate your PMI payments.
Eliminate Your Mortgage Insurance Premiums (MIP)
Both MIP and PMI protect your lender’s investment, but MIP only applies to FHA loans. FHA loans issued before June 2013 are eligible for MIP cancellation after five years for homeowners with 22% equity or more. FHA loans obtained after June 2013 must refinance into a conventional loan to get rid of their MIP payments, regardless of their current home equity.
Change Your Loan Type
As the market conditions and your personal finances change over time, you may outgrow your loan type. For instance, refinancing and adjustable rate mortgage before it resets will insure that your monthly payments remain stable. Just as changing an adjustable rate mortgage to a fixed-rate mortgage can save you money in the form of interest, rising house prices help you pay off your mortgage sooner. Talk to your credit union or bank about refinancing a jumbo mortgage or other loan options that might be available to you.
How to Know If Refinancing Is Right for You
Refinancing is not for everyone. Whether you qualify to refinance your home will depend on several factors such as your credit score and home equity. During the qualification process lenders will review your creditworthiness, just like when you first purchased your home. Before applying for a refinance mortgage, ask yourself the following questions:
How Much Equity Do You Have in Your Home?
Calculate the equity in your home by subtracting your mortgage balance from a current market appraisal value. The difference is your equity. Refinancing requires a minimum of 5% equity but 20% is ideal. Generally, the more equity you have, the easier it is to refinance.
What Is Your Debt-to-Income Ratio?
Before issuing a new monthly payment, lenders need to know whether you can afford it. To calculate your buying power, lenders compare your monthly expenses to your income, also known as your debt-to-income ratio. Most lenders will not approve a monthly payment higher than 30% of your gross income. Furthermore your overall debt-to-income ratio, which includes student loans, car payments, child support, and other financial obligations, should be below 43%.
Do You Have a Second Mortgage or Lien on Your Home?
Other loans and liens may hinder the refinancing process. Before refinancing, consider resolving all liens and paying off any home equity loans. Luckily, these exceptions do not make refinancing impossible. Additionally, refinancing can help you consolidate two mortgages into one.
Do You Owe More Than Your Home Is Worth?
Owing more than your home’s current value is called negative equity. Often, negative equity will prevent you from refinancing. However, there are special programs designed to help people refinance such as Fannie Mae’s High Loan-To-Value Refinance program. If you have negative equity, check with your lender to see if you qualify for these programs.
Is Refinancing Your Home Really Worth It?
Is now the right time for you to refinance your home? Everyone's financial situation is unique and affected differently by the economic climate. For example, if you borrowed big on a jumbo loan a few years ago, the equity you have in your home might still make it a smart move to refinance to a 15-year loan. When you ask yourself, “Is it the right time to refinance to a 15-year mortgage?” remember you cannot predict the future. Instead, focus on what you can control. Here are some key questions to ask yourself before you refinance:
Can You Afford to Refinance Your Home?
Closing costs for a refinanced home loan range between 2-4% of the total loan amount. If you do not have that kind of cash on hand, you may be able to roll these costs into your loan, but you will end up paying more interest over time. Other costs you may need to pay include origination, title search, appraisal fees, point buy downs, local taxes, and other fees.
Will You Get Stuck Paying More When You Refinance?
Before you refinance, consider the amount of interest and principal you have already paid into your home. While refinancing can significantly lower your monthly payment, you may end up paying far more in the long run, depending on the type of loan and terms you choose. Switching to a shorter-term loan, such as a 15-year fixed one, could help you pay less overall, but will also mean higher monthly payments. Use our mortgage calculator to compare the costs of your current mortgage to a refinanced loan.
Are You Planning to Move Soon?
If you and your family are planning to move in the near future, then refinancing to a 15-year loan may not be worth it. Before deciding to refinance your home, make sure to plan on staying long enough to recoup the closing costs. For example, if your closing costs were $2,500, but you saved $100 a month, then it would take you 25 months, or about two years, to recoup those costs. If you leave before the 25 month mark, refinancing could cost you more.
Take the Next Steps with Confidence
Once you've decided to refinance, start by defining your goals and selecting a loan that fits your needs. Shop around for lenders to find the best rates and fees, and lock in a low rate as soon as possible. After closing, celebrate the financial stability you've secured for your home and family.