Article written by: By Kira Botkin and posted on Moneycrashers.com
You’re probably already aware that a refinance can lower your monthly payment. However, a lower interest rate can also allow you to more quickly build up equity and pay off your loan balance. When you pay your mortgage each month, look at your statement carefully. Because your mortgage is amortized over a long period of time, typically 30 years, interest payments make up a significant chunk of the monthly payment, particularly during the first ten years of your loan.
When you refinance your mortgage to a lower interest rate, the amount you pay in interest will go down. Moreover, if the term of your new mortgage matches how many years remained on your original mortgage, the amount you pay toward principal will go up. If you can afford it and don’t have other high interest debt, a good strategy is to direct the amount of money you save from a refinance toward extra principal payments. In this way, your monthly mortgage amount doesn’t change, but you can pay off your home much faster.
In most cases, a refinance that involves removing private mortgage insurance (PMI) will also help save you money. If your house has more than 20% equity, you will not need to pay PMI, unless you have a FHA mortgage loan or are considered a high-risk borrower. If you pay PMI and your current lender won’t remove it even though your house has at least 20% equity, you may want to consider a refinance for this reason alone.
Factors to Consider Before Refinancing
Consider the following to get a sense of how likely a refinance is to help you, if you’re eligible for one, and how to go about structuring it:
1. Current Interest Rate
Simply put, if you can get into a lower rate mortgage, a refinance is worth looking into. That said, consider how long it will take you to recoup closing costs.
For example, if you paid $2,000 to refinance your mortgage to a lower rate and your payment dropped by $150 per month, it will probably take you just over a year to break even. Generally, at least a half point to a full point reduction in the interest rate will save you enough money to cancel out the closing costs within a few years.
2. Jumbo Loan
If your initial mortgage was a “jumbo loan,” but you have since paid down the balance to less than $417,000, you may be able to get a “regular” refinance. In other words, there’s a good chance you’ll qualify for a lower interest rate even if rates in general have not gone down significantly.
3. Closing Costs
Since every mortgage, including a refinance, has fees associated with it, you need to understand how you’ll be paying them and if even it makes sense for your situation.
For example, in a “no cost” mortgage, you are either tacking the fees onto the loan balance or accepting a higher interest rate to cover those fees. If you can afford it, you’ll save money over the long-term by paying the fees out-of-pocket. However, if you can’t afford it and plan to stay in your house for a while, adding the fees to your loan balance is likely to work out better than accepting a higher interest rate. But if you expect to move over the next few years, accepting the higher interest rate will be more advantageous.
Consider your whole financial picture when determining whether or not to finance your closing costs. For example, if you have high interest credit card debt, but have cash on hand to afford the closing costs, it might make sense to pay off the high interest debt and finance the closing costs instead. Then, you can direct the payments that would’ve gone to your credit card to your home loan. In this way, you could pay off the closing costs faster than you could have paid off the same amount of credit card debt.
4. Mortgage Prepayment Penalty
Some mortgage brokers and banks offer loans that have a mortgage prepayment penalty. While a loan with a prepayment penalty usually has lower fees or a better rate, if you pay the loan off early, you’ll owe a fee which can be steep. The penalty is in place for a set period of time and can sometimes go down with time. But if you want to refinance your mortgage before the prepayment penalty expires, you’ll have to pay the penalty, which can ultimately make refinancing more expensive than it’s worth.
5. Length of Time You Stay in the Home
This is important in the context of closing costs and especially if you’ll consider a new loan with a prepayment penalty. When it comes to closing costs, you want to make sure you recoup the expense before you move.
For example, if you paid $2,000 in closing costs and you now pay $100 less in interest each month, it will take 20 months before you actually break even and start seeing real savings. If you financed those closing costs by adding them onto the loan balance, it will take even longer.
If you aren’t planning to be in your home for at least two years, it’s probably not worth refinancing at all – unless, perhaps, you refinance from a very high rate to a much lower one, or if you trade out-of-pocket closing costs for a higher interest rate that is still lower than your original mortgage rate.
If you’re entertaining the idea of tacking a prepayment penalty onto your new loan to get a lower rate, you should be committed to staying in your home through the prepayment penalty period, which could be as long as five years or more.
6. Your Credit Score
If your credit has improved since you got your original mortgage, you may now qualify for a lower rate. Check your credit report before you begin the process to confirm whether or not this is the case. Often, a few years of timely mortgage payments will improve your score such that you qualify for a lower interest rate.
Also, compare your debt and income now to what it was when you took out the original mortgage as banks generally require that your debt to income ratio fall below 36%. If you’ve since accumulated significant debt or if your income has declined, you may not qualify for a lower rate or a refinance at all in spite of stellar credit.
7. Amount of Equity in Your Home
Most lenders want to see some amount of equity in order to qualify you for a loan. Generally speaking, the more equity in your home, the easier it will be to refinance. A minimum of 20% is ideal, but you may still be eligible for a refinance even if you have less, such as 10%. However, the terms may not be as favorable.
To refinance with low or no equity, see the “Special Situations” section below.
8. Adjustable-Rate or Balloon Mortgage
Most people who have an adjustable-rate mortgage or a balloon payment mortgage count on refinancing at some point if they plan to stay in their home. Since refinancing can take a while, give yourself enough time to apply and get approved before your rate adjusts or your balloon payment comes due. Double-check your loan documents to make sure you know exactly when this date is and plan ahead.
9. Loan Term
Many people refinance into a new 30-year mortgage over and over, and never get closer to the goal of owning their home outright. Since interest makes up the large majority of your payments in the first ten to fifteen years, you will pay a lot more in interest if you keep resetting the clock.
Therefore, it’s generally a good idea to request a loan term as long as the number of years remaining on your original mortgage, as long as you can afford it. This allows you to pay off your mortgage according to the original schedule, while still reducing your rate. You can even refinance into a shorter term, which may raise your payment, but could get you an even better rate and set you up to pay the loan off sooner.
Remember, don’t focus on the monthly payment to the exclusion of the loan’s term, your rate, and closing costs. For example, some unscrupulous mortgage broker may show you a loan with a lower payment that actually has a 30-year term, high expenses, and a rate that isn’t much lower than the rate on your current mortgage.
10. People Listed on the Refinanced Mortgage
Generally, if you’re trying to add or remove someone from a mortgage, such as after a marriage or divorce, the lender will require you to refinance. This is done to determine whether or not the other person will qualify, or if you will qualify alone.
However, you may be able to work something out with the mortgage lender in order to accomplish your goal without going through a full refinance. This is especially true if the person who will have been on both mortgages can qualify for the mortgage by themselves.
11. Second Mortgage or Home Equity Loan
If you have a second mortgage, a home equity loan, or a home equity line of credit (HELOC), you may be able to save a lot of money by refinancing that into your primary mortgage.
To determine if you can, add up all your home loans together. If your home’s current value exceeds the value of the loans, you may be able to refinance your loans into one. In this way, you’ll pay one low rate on the entire amount instead of one low rate on your primary mortgage and a higher one on the second.