One of the most common questions that homeowners ask themselves is if they should refinance their mortgage. It can feel like a complicated game of chess, trying to understand the policies of various lenders, changing interest rates, and the cost-benefit analysis of making this big financial move. With a little research and some careful consideration, homeowners can avoid common refinancing pitfalls and set themselves up for future financial success.
What Is Refinancing?
Refinancing means paying off an existing mortgage by replacing it with a new one. Through refinancing, homeowners can start from scratch by renegotiating the terms of their loan, including interest rates, term, or type of loan. They can even change lenders or brokers. Refinancing restarts the terms of the loan and can significantly decrease home equity, but may help you save money in the long run by paying lower interest rates. Homeowners still have to qualify for refinancing, and go through a similar process as when they initially took out their mortgage. Responsible lenders will make sure that debts don't outweigh income, and that homeowners will be able to comfortably make monthly mortgage payments.
Why Should I Refinance?
- Lower Interest Rates It can be a good idea to refinance when current interest rates are lower than the interest rates on your loan. Traditionally, experts recommend that if you will lower your interest rates by 2% or more through refinancing, it may be a great option for you to lower your monthly payments and help build home equity quickly. Other factors are important in considering this cost-benefit analysis, including the length of time you plan to stay in your home and your current credit score. For example, if you have been making your mortgage payments in full and on time each month, you may qualify for a lower interest rate than when you originally took out the mortgage for your home. Check out this tool to see how many months it will take you to reap the benefits of your decreased monthly payments. If you plan to stay in your home longer than that amount of time, it may be a good idea to refinance.
- Changing the Length of Your Loan Some homeowners may wish to shorten the term of their loan, reducing the amount of money they will have to pay in interest over the course of the loan, though this option increases monthly payments. Others may choose to lengthen the term of their loan. This reduces monthly payments in the short term but increases the amount of interest the loan will accumulate over time. Depending on your financial situation, changing the length of your loan may be a smart move.
- Converting the Rate of the Mortgage Switching the rate of your mortgage (either Fixed or Adjustable Rate Mortgage) is another possible cause for a refiance. Homeowners may decide to take advantage of a favorable housing market with an Adjustable-Rate Mortgage. Some homeowners may feel uncomfortable with an Adjustable Rate Mortgage, because it means that their mortgage rates may increase or decrease over time, depending on the market. They may choose switch to a Fixed-Rate Mortgage and lock in favorable rates.
- Using Home Equity Though sometimes financially unwise, homeowners can use refinancing as an option when they are in need of a large cash advance. Financing a child's college education, consolidating debt, or paying medical bills may be reasons to tap home equity during a home refinance.
What Are The Costs of Refinancing?
Refinancing will come at a significant cost, no matter what your lender tells you. First, you may have to pay an initial application fee to process the request and check your credit. This will range from $75-$300. Then, you will have to pay for the time of your lender; after all, they don't work for free. To evaluate and prepare your loan, they will often charge a small percentage of your loan principal. During the refinancing process, you may have to pay an appraisal fee, an inspection fee, and an attorney fee to prepare documents. Some lenders may charge a prepayment penalty; or a fee incurred for paying your mortgage early. While some states and lending institutions prohibit this fee, it could cost you between one and six months of interest payments.
Some lenders may offer to pay some of these costs upfront and add them to the total of your refinanced loan, allowing you to take advantage of low interest rates for little to no out-of-pocket expense. Keep in mind that you will pay interest on these expenses for the full life of the loan when performing your cost-benefit analysis.
Best Refinancing Tips
- Shop around. Don't just check for the best interest rates: look at the big picture. What other costs will you incur with different lenders? By law, lenders are required to provide you with a detailed estimate of loan terms within three days of your loan application, including closing costs. Many of the costs of refinancing can be negotiated. Therefore, it's in your best interest to check at several lenders, and make it known that you are going with the best possible rates. Try using this free worksheet from the Federal Reserve to help you in the comparison process.
- Timing is Key. Many experts recommend that the best time to refinance is early in the life of your mortgage, before you have had a chance to build significant equity. However, it may still be financially savvy to consider a refinance later in the life of your loan, depending on the amount of money you stand to save. Besides considering timing in the life of your loan, it's important to consider your housing market and current interest rates.
- Think about your ten-year plan. Do you still plan to be living in your home ten years down the line, or is it a starter home that you'd like to upgrade in a few years, as you add to your family? The longer you stay in your home, the more time you will have to cash in on the potential savings from a home refinance. No matter what your plan is, make sure you crunch the numbers and determine the amount of time that you will have to reside in your home to make the refinance worthwhile. Then, compare that number to your family's goals and future plans.
Know your ideal rates, read the documents, and don't forget to ask questions throughout the process. Refinancing is often stressful enough that many homeowners would rather pay a higher interest rate than deal with the process. Don't let that be you! A well-informed financial future is within your reach.