Whenever interest rates drop, you hear about homeowners refinancing their mortgages to save money on interest. A savvy homeowner can save loads of money by refinancing their home loan at the right time with a lower rate.
When you refinance, you’re paying off an existing mortgage and replacing it with a new mortgage loan, typically one with a better interest rate or more favorable payment terms.
For example, a homeowner might refinance a 30-year mortgage to a 15-year mortgage at a lower interest rate to save tens of thousands of dollars that he or she would have otherwise paid over the life of the original loan. Some people refinance with the same loan term but at a lower interest rate to reduce the monthly payment.
Refinancing your mortgage could be one of your smartest financial moves. In certain situations, however, the costs of refinancing might outweigh the financial benefits you hope to gain.
If you’re thinking about refinancing, you’ll find answers in this guide to the most common questions homeowners like you ask about refinancing a mortgage. Read on how to determine whether refinancing is right for you and how to find a lender.
1. What Do I Need to Be Eligible to Refinance?
Remember that approval process you went through when you bought your house? You’ll have to go through the whole thing again when you refinance. The lender will consider your income and assets, credit score, how much other debt you have, the value of your home based on an appraisal and how much money you want to borrow.
You’ll also need to meet the lender’s guidelines for the loan-to-value (LTV) ratio. LTV compares the amount you still owe on your original mortgage with the property’s appraised value.
For example, if the current appraised value of your home is $200,000 and you still owe $160,000 on your mortgage, that would be an 80% LTV ratio ($160,000 is 80% of $200,000). That also means you have 20% in home equity. If you don’t meet the lender’s LTV ratio requirement, the lender might reject your application or offer a loan with less favorable terms.
According to Discover Bank, you might be able to get a conventional refinancing with only 5% equity. However, if your equity is less than 20%, you’ll probably be saddled with higher interest rates and fees, and have to take out private mortgage insurance (PMI) on the new loan.
If you have a Freddie Mac loan and your LTV exceeds Freddie Mac’s maximum for standard refinancing, you still might be eligible for Freddie Mac’s Enhanced Relief Refinance program.
2. Why Should I Refinance My Mortgage?
You can decrease the term of the loan.
Refinancing can save thousands of dollars you otherwise would have paid on interest over the life of the loan.
For example, if you refinance a 30-year, fixed-rate loan of $200,000 at 6% ($231,640 total interest) to a 15-year fixed-rate loan at 5.5% ($94,120 total interest), you’ll save $137,520 in interest paid over the term of the loan. Decreasing the term of the mortgage typically raises payments, but the upside is that the loan is paid off much sooner.
You can increase the term of the mortgage.
Someone also could refinance a 15-year mortgage to a 30-year mortgage to lower the monthly payments. However, refinancing to a longer-term will increase the amount you pay over time. It’ll also take much longer to pay off your home when you increase the loan term.
You can obtain a more favorable interest rate.
If interest rates fell since you took out your mortgage, you can save money on monthly payments by refinancing at a lower interest rate even if you don’t reduce the loan term.
For example, let’s say you have a 30-year loan for $200,000 at a fixed rate of 6% and a monthly payment of $1,169. If you refinance for the same term at an interest rate of 5.5%, your monthly payments will drop to $1,136. That’s a savings of $756 annually or $7,560 over 10 years
Keep in mind that those monthly and annual savings are short-sighted. You still make payments for 30 years. Plus, the money saved on lower monthly payments pales in comparison to the $137,520 you’d save over time if you reduced your 30-year mortgage at 6% to a 15-year term at 5.5%.
You can change from one adjustable-rate mortgage (ARM) to another.
Refinancing from an ARM where the next interest rate adjustment will raise your monthly payments to an ARM with better terms such as a lower starting interest rate, smaller interest rate adjustments or lower payment caps (where the interest rate can’t exceed a certain amount) could be a reason to refinance, according to the Federal Reserve.
You can get cash from the equity in your home.
The gap between the balance owed on the mortgage and the actual value of the property is what’s known as home equity. In a cash-out refinance, the homeowner refinances for an amount greater than what is owed on the home.
For example, if your home is appraised at $200,000 and the balance owed on the mortgage is $100,000, you might be able to receive cash from the $100,000 in-home equity when you refinance. People might use cash-out refinancing to pay off credit card debt, pay for college or make home improvements.
It’s not free money, though. Any amount of cash received gets added to your new mortgage loan amount. Many financial advisers caution against using cash-out refinancing to pay off unsecured debt such as credit cards or car loans, according to the Federal Reserve, which recommends seeking alternatives to cash-out refinancing.
“If you are considering a cash-out refinancing, think about other alternatives as well. You could shop for a home equity loan or home equity line of credit instead. Compare a home equity loan with a cash-out refinancing to see which is a better deal for you,” the Federal Reserve recommends.
3. When Is Refinancing Not a Good Idea?
In some situations, refinancing your mortgage might not be wise, according to the Federal Reserve. These situations include:
When you’ve been paying on your mortgage for a long time.
That’s because, in the early years of your mortgage, the amortization process dictates that most of your monthly payment goes toward interest. But in the loan’s later years, more of your payment goes toward the principal to help build equity.
For example, let’s say your original loan was a 30-year, fixed-rate mortgage of $135,000 at 4.5% interest with a monthly payment of $684. In the first month, $506 of that payment would be credited toward interest and only $177 toward the principal. However, by the 180th month, midway through the 30-year term, only $335 goes toward interest, with $349 earmarked for the principal.
When you refinance, the amortization process restarts, which means that in the early years of your new mortgage, most of the monthly payment will again go toward interest, not toward building equity.
Your current mortgage imposes a prepayment penalty.
Some lenders might charge a prepayment penalty, up to six months of interest payments, if you pay off your mortgage early. If you’re refinancing with the same lender, you can try getting the prepayment penalty waived. “You should carefully consider the costs of any prepayment penalty against the savings you expect to gain from refinancing,” the Federal Reserve advises.
You plan to sell your home in the next few years.
If you sell your house a few years after you refinance, the costs associated with refinancing might outweigh any savings on monthly payments. It’s also likely that most of your monthly payment still will be going mainly toward interest, so you might not have enough home equity to walk away with a decent profit when you sell the house.
4. What Costs and Fees Are Involved in Refinancing?
It’s common to pay 3% to 6% of your outstanding principal in refinancing fees, which vary by lender and state, according to the Federal Reserve. Costs of refinancing can include:
- Application fee. $75 to $300.
- Loan origination fee. Up to 1.5% of the loan principal.
- Points. A point is equal to 1% of the amount of your loan. A lender or broker might charge one-time points to reduce your interest or to earn money on the loan. Cost: Up to 3% of the loan principal.
- Appraisal fee. The lender must verify that your property is worth at least as much as the loan amount. Cost: $300 to $700.
- Inspection fee. The lender might require a termite inspection, structural analysis, or a septic or water system test. Cost: $175 to $350.
- Attorney review/closing fee. Cost: $500 to $1,000.
- Homeowner’s insurance. The lender will require that you have a homeowner’s insurance policy in effect at closing. Cost: $300 to $1,000.
- Insured loans and guarantee program fees. Loans that might require fees are those insured by the Federal Housing Administration (FHA) and Rural Development Services (RDS), and loans guaranteed by the U.S. Department of Veterans Affairs. Conventional loans where the amount borrowed exceeds 80% of the home’s value will require PMI. Cost: FHA: 1.5% plus 0.5% per year; RDS: 1.75%; VA: 1.25% to 2%; PMI: 0.5% to 1.5%.
- Title search and title insurance to ensure ownership and check for liens. Cost: $700 to $900.
- Survey fee. If a survey for the property was done recently, you might not have to pay this fee. Cost: $150 to $400.
5. What Is No-Cost Refinancing?
No-cost financing lets you avoid upfront fees.
One method of no-cost financing is when the lender pays for closing costs but charges a higher interest rate over the life of the loan. Another example of no-cost financing is when refinancing fees are “rolled in” as part of the principal on your loan for you to pay interest on over the life of your loan. In other words, even “no-cost” isn’t free when it comes to refinancing your mortgage.
6. How Can I Find the Best Refinancing Deal?
The Federal Reserve recommends comparison shopping for the best refinancing deal, possibly starting with your current lender, which might eliminate some of the typical refinancing fees to keep your business.
Within three business days of your application being submitted, a lender must provide a “good faith” estimate of all costs involved in the closing. Obtain estimates from several lenders to help you decide which one to choose.
“Choosing a mortgage may be the most important financial decision you will make,” according to the Federal Reserve.
“You should get all the information you need to make the right decision. Ask questions about loan features when you talk to lenders, mortgage brokers, settlement or closing agents, your attorney, and other professionals involved in the transaction — and keep asking until you get clear and complete answers.”