There has been a lot of discussion about refinancing loans right now, especially as COVID-19 led to record low interest rates in the U.S. But, is refinancing your mortgage really a good idea? While lower interest rates are certainly enticing, there are many other factors to consider when it comes to your mortgage. Here, we discuss some of the most important things to think about before deciding to refinance your mortgage.
Understand refinancing
Simply put, refinancing means paying off an existing loan by taking out a new one. While the terms may change, essentially your debt remains the same. People choose to refinance loans for many reasons, but the most popular include pursuing more favorable repayment terms, to get money to cover an emergency or other large expense or to switch lenders.
Refinancing comes at a cost
While the process for refinancing varies by the type of loan, refinancing a mortgage has a price. In addition to paying for an appraisal, title search, and application fees, refinancing may cost up to six percent of your loan’s principal value.
There are qualifications
Refinancing is not for everyone. Just like with your original loan, there is an application process for refinancing a mortgage. Once you select a lender, the lender will evaluate your situation to decide if you qualify for refinancing and under what terms. Lenders will review your original mortgage for payment history and assess equity. They are looking for at least twelve consecutive months of timely payments and want to see that you have at least ten to twenty percent equity in your home.
Your income, debt, and credit history are all considered with your application to refinance. Lenders look for a stable income. Your debt-to-income ratio must be low enough that other debt payments will not adversely affect your ability to make timely mortgage payments. Credit is one of the most important factors in determining your repayment terms for a refinanced mortgage. The higher your credit score, the lower your interest rate.
Have a clear purpose for refinancing
There are good reasons for refinancing your mortgage, and there are unwise reasons behind the decision. Make sure that your motivation for refinancing your mortgage is appropriate.
Lower your interest rate
There are short and long-term benefits of lowering your interest rate. In addition to lowering your payment, the life of your mortgage may be cut short by lowering the interest rate. This will save you money in the long run by reducing the amount of interest you pay on the loan. But, how much do you need to lower your interest rate for refinancing to be worth your while?
Generally, if you can lower your interest rate by at least two percent, refinancing may be worthwhile. However, in some circumstances, even a one percent reduction may be worthwhile. It ultimately depends upon your financial goals and the nature of your loan.
Refinancing your mortgage to lower your interest rate can also help you build equity in your home. A lower interest rate can lower your monthly payment, helping you save money. These savings increase the rate at which you build equity.
Change your mortgage type
In general, there are two types of mortgages: fixed-rate and adjustable-rate or ARM. Which type of mortgage is best depends greatly on how long you plan to say in your home. While ARMs may initially have a much lower monthly payment, the periodic adjustments to your rate could easily drive your interest rate much higher than what you would find in a fixed-rate mortgage. The higher the interest rate, the higher your monthly payment will be and the longer it will take you to pay off the debt.
When interest rates fall, as they did in the global health crisis caused by the COVID-19 pandemic, switching from a fixed-rate mortgage to an ARM can lead to significant savings by lowering your interest rate and reducing your monthly payment. However, keep in mind that interest rates fluctuate and an ARM loan has the flexibility to regularly increase the interest rate on your loan to mimic market trends.
Changing from a fixed-rate mortgage loan to an ARM can shorten your repayment period on the loan. If the life of your original loan exceeds thirty years, you can refinance your mortgage to reduce the repayment period to fifteen years at a fixed rate. This would keep the payment at or below twenty-five percent of your take-home pay.
Consolidating debt or borrowing against home equity
Refinancing your mortgage as part of a consolidation loan or to get cash during a financial crisis can be a risky move for your financial health – but it is not uncommon, nor is it inadvisable in every case. While there are times when refinancing for one of these purposes is a viable option, don’t take the decision lightly: Replacing debt with more debt or borrowing against your home equity can open the door for a debt crisis. Refinancing to fund your child’s college or a home remodel may give you the benefit of the lower interest rate found in a mortgage, as opposed to more challenging terms found with other types of loans. However, keep in mind that it takes years to recover the cost of refinancing – which could be up to six percent of the principal of your mortgage.
Refinancing your mortgage is a decision that requires a lot of thought and careful consideration. Avoid refinancing unless the financial benefit will provide immediate and long-term benefits. Always be forward-thinking. Refinancing your mortgage to fund an unnecessary expense or to take advantage of a lower interest rate when you have no plans to stay in the home long anyways can set you up for financial hardship, especially if you were to experience a sudden reduction in income or other financial strain.
