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Should I Refinance My Mortgage?

Many homeowners resort to mortgage refinance practice for a variety of reasons. However, it's a big decision that should be examined carefully. How to know if you should you refinance your mortgage?
Author: Russell White
Russell White

Writer, Contributor

Experience

As a finance geek and Content editor with 13 years of journalism experience, Russell makes sure every article has the right flow, edits for accuracy, and consumer value. In addition, Russell contributes his own ideas about budgeting, savings, and credit cards.

Review & Fact Check: Baruch Mann (Silvermann)

Russell White

Writer, Contributor

Experience

As a finance geek and Content editor with 13 years of journalism experience, Russell makes sure every article has the right flow, edits for accuracy, and consumer value. In addition, Russell contributes his own ideas about budgeting, savings, and credit cards.
Author: Russell White
Russell White

Writer, Contributor

Experience

As a finance geek and Content editor with 13 years of journalism experience, Russell makes sure every article has the right flow, edits for accuracy, and consumer value. In addition, Russell contributes his own ideas about budgeting, savings, and credit cards.

Review & Fact Check: Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

Financial Expert, The Smart Investor CEO

Experience

Baruch Mann (Silvermann) is a financial expert and founder of The Smart Investor. Above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.

You can trust the integrity of our unbiased, independent editorial staff. We may, however, receive compensation from the issuers of some products mentioned in this article. See how we make money.

Table Of Content

A 2021 survey conducted by ICE Mortgage Technology, Inc shows younger millennials had a lower refinance mortgage at 24%, compared to older millennials at 52%. In contrast, younger millennials took the lead with purchase mortgage at 75% against 47% recorded by the older millennials.Chart: Mortgages Taken Out by Millennials in the U.S. 2020, by Type of Mortgage

When Is It A Good Idea To Refinance Your Mortgage?

Mortgage refinancing is a wise recourse under many circumstances. Here are some of them:

1. Mortgage Rates Have Dipped

The primary motivation to refinance is to lower or lessen interest costs.  This is why most of us refinance not just mortgages but just about any loan that qualifies for that option – auto loans, student loans, or even credit card obligations. No less than the White House mentioned that the average homeowner could save around $3,000 per annum by refinancing their homes.

As you consider whether the lower rates would justify refinancing, carefully take note of the following facts:

  • While mortgage rates have gone down, predicting future interest rates with utmost certainty is a fantasy. Most analysts have predicted that rates will go up in the coming months.  Anyway, make a decision whether or not to refinance based on today’s prevailing rates and not on a prediction of future trends.
  • Your potential savings on the new loan do not depend on the interest rates alone. Mortgage brokers will predictably pitch the lower monthly payment but remember that your monthly payment will also depend on the term of the new loan. If you have 20 years remaining on your old mortgage and refinance it back to a 30-year term, your monthly payment will be lower even at the same interest rate.
  • It is also important to consider the tax implication of a refinance. While it may be true that a lower interest rate would lower your monthly interest expense, it would also decrease your tax deductions and effectively increase your taxable income. The monthly savings could be insignificant when the tax liability is taken into account.

According to data obtained from Freddie Mac, the interest rate on a 30-year conventional mortgage has been on a gradual decline. In 1975, the rate of the 30-year conventional mortgage was 13.74%, and it has declined to 3.08% in 2021. Mortgage lenders lower mortgage rates as a way of stimulating growth in the housing market.

Chart: Rates on 30-Year Conventional Mortgage in the U.S. 1975-2021

2. Refinance to Reduce The Term of Your Loan

If the original term of your loan is 30 years, it might be a wise decision to refinance now.  With the present low-interest rates, a new 15-year mortgage is not much more expensive than the 30-year mortgage you have been paying off.

Use a mortgage calculator to determine what the new payment would be.  If the new estimated payment is reasonable, consider getting in touch with your bank or mortgage broker.

3. Refinance to Switch from a Flexible to a Fixed Mortgage Rate

If you have previously opted for an adjustable-rate mortgage (ARM), it may be a perfect time to refinance into a fixed-rate mortgage.

The low-interest rates will not be here forever so locking into a lower rate now is your protection when rates do escalate in the coming years.  Moreover, it is easier to budget and plan for a fixed payment.

 

What You Should Know Before Refinancing?

Here are some things you should know before refinancing

  • Home equity value: When refinancing, the first thing you should know is the value of your equity in your home. This would determine how much loan would be made available for you. Lenders usually frown at borrowers with little or no home equity. However, homeowners with at least 20% equity will find it easy to obtain a new loan.
  •  Credit Score: Your credit score is perhaps the most significant factor that determines how much loan you are eligible for and your interest rates. Lenders usually prefer a credit score of 760 or higher to qualify for the lowest mortgage interest rates.
  • Debt-to-Income Ratio: DTI ratio specifies how much of your income goes to paying debts. A high DTI ratio indicates that you have much debt and a low probability of paying back, which is not a good sign to lenders. lenders usually lookout for a DTI ratio of 36% or lower.
  • Refinancing costs: Refinancing a home usually costs between 3% and 6% of the total loan amount, though some lenders offer a “no-cost” refinance. There are several ways borrowers can find reduce refinancing costs. For example, if you have enough equity, you can reduce the costs by rolling them into your new loan (and thus, increase the principal).

How Does Refinancing Mortgage Affect Credit Score?

Refinancing can lower your credit score in a couple of ways. Anytime you apply to refinance a loan, lenders conduct a hard inquiry into your credit score and credit history. This can cause your credit score to drop slightly. This effect is further exacerbated if you apply to different lenders which means they would all conduct a hard inquiry into your credit score.

However, the money saved through refinancing usually outweighs the negative effects of a small credit score dip.

How to Calculate If Refinancing Can Save You Money?

So now you may be asking:  “How much lower must rates be to justify refinancing?”.

You will find a number of conventions on this, currently ranging from 0.50% to 4%.  A more conservative approach is to do the actual math. All it takes is a few steps.

  • Determine the amount you will save in monthly interest. The actual amount will go down as you pay off your mortgage but for a quick estimate, the first month’s savings will do.
  • Reduce the interest savings by your marginal tax rate to reflect the smaller tax deductions. Do this only if you itemize your deductions.
  • Determine the total refinancing cost of your mortgage. Your bank or broker would likely have this information in your account file.
  • Lastly, divide the total refinancing cost of your mortgage by your monthly after-tax savings. The resulting figure denotes the number of months it will take you to reach the breakeven point.  If you are planning to stay in that house longer than the time to breakeven, then refinancing is a sensible choice.

With these steps, you can see why it is better to focus on the total refinancing cost than just on the interest rate.

Should You Refinance to Decrease Your Monthly Payments?

Decreasing your monthly payments will definitely create a positive impact on your budget. But before you decide if refinancing is for you, check out some of these details:

1. Potential Benefits of Lower Monthly Payments

Lowering your monthly loan payments through refinancing (either by getting a lower interest rate or by extending the term) can make it easier for you to pay your mortgage on time every month and possibly provide enough surplus funds to service other debts and expenses.

Also, if you are apprehensive about your capacity to pay the current monthly level in the future, lowering your monthly payments will help relieve you of the anticipated financial pressure.

2. Refinancing Costs

When you refinance, you will be paying for closing costs. Additionally, the common practice would be to refinance for the same term as the original loan.  This means starting another 30-year loan after a lapse of so many years off the original term on a home that you already own.

In effect, you’ll be paying more in terms of aggregate interest over the total life of the loan. While the monthly mortgage payment would appear to go down, your total cost over the entire term would likely go up.  It’s vital that you talk to your lender about your situation and make sure that you will be comfortable with how these costs will play out in your overall financial situation.

3. Your Mortgage Breakeven Point

The breakeven point is that moment in the term of the loan when the total reduction in your monthly payment becomes equivalent to your total financing costs. If you have plans of selling your home in the future, you probably would not recover your closing costs if you sell it before reaching the breakeven point.

Here is a sample computation of breakeven point:

$5,000 in total closing costs ÷ $200 in monthly payment savings = 25 months (to break even)

4. Your Credit Score Has Improved

Even if interest rates don’t go down, you may still qualify for a lower rate if your credit score has gone up.

According to my FICO, current mortgage rates may vary as much as 1.70% depending on a person’s credit score.  This means for a $250,000 mortgage, an incremental 1.70% interest due to a mediocre credit score will impose an additional $250 on your monthly mortgage payment. Here's how to get your credit score for free.

To nail the best mortgage rates, aim to get a FICO score of 735 or higher.  In case you have no idea what your current FICO score is, there are many ways to get your FICO score for free.

What Are The Steps Of Refinancing Your Mortgage?

After you got a decision, it's important to explore and understand the different options, and carefully review the different terms. Also, setting your goals before shopping around can help during the refinancing process.

  • Set your goal for refinancing: Clarify which goal you intend to achieve and why you would want to refinance your loan. Is it to reduce your monthly payments, shorten the loan term or get rid of mortgage insurance? Having a goal enables acts as a peer-review mechanism and keeps you on track when you want to deviate.  Reduce monthly payments? Shorten the loan term? Get rid of FHA mortgage insurance?
  • Shop for the best mortgage refinance rate: After clarifying your objectives, the next thing to do is shop around for the best refinance rates. Try to get quotes from as many lenders as possible to know which deal best suits you. Don’t be afraid to shop around and compare each lender’s current rates, availability, and client satisfaction scores.
  • Apply: When you apply to refinance, you would be expected to resubmit the same information you used when buying your home such as income source, tax documents, assets et al. If you are married, the lender may also request for your spouse’s documents. It’s a good idea to apply to as many as 5 lenders. Try to do this within a two-week time frame so that the effect would be minimal on your credit score.
  • Lock your interest rate: When you get an interest rate that suits your payment schedule, you should consider lock in immediately. Be aware that your interest rate can’t be changed during the lock-in period. You and the lender will try to close the loan before the rate lock expires. 
  • Close the loan: This is the final stage of the loan refinancing process. Here, you pay the closing costs  listed in the Loan Estimate and Closing Disclosure.

FAQs

Yes, you can refinance from an ARM to a fixed rate mortgage. As with any refinancing, you should get some quotes and compare them to your current rate and deal.

This will allow you to determine whether it is better to stick with your ARM package or if a fixed rate is available to you that will save you money each month and over time.

If you intend to sell your home, refinancing may not be the best option. You will incur costs and fees as a result of refinancing, which you may not be able to recoup during the time you live in your home. Furthermore, if you are locked into a contract, you may be charged early repayment fees if you sell.

In general, if you intend to sell within the next five years, deferring refinancing is a good idea. The only exception may be if you intend to use the funds for home improvements that will increase the value of your home. This may make refinancing feasible, offsetting any costs and allowing you to save money before you move.

If you have bad credit, you may be able to refinance your mortgage, but the rates and deals available to you will be influenced by your credit score. When you apply for a new loan, your new or current lender will conduct a credit check.

As a result, you may discover that your new offer has a higher interest rate or worse terms than your current mortgage. In this case, you should keep your current loan and consider refinancing after you've had a chance to improve your credit score.

If you are currently in a forbearance agreement with your mortgage lender and want to refinance, you must restart your monthly payments. This means you must contact your lender to terminate the forbearance.

Before you can begin the refinancing process for most conventional loans, you must make at least three consecutive on-time monthly payments.

Based on data obtained from Freddie Mac on the Forbearance rate in 2021, New York had the highest forbearance rate at 5.17% followed by New Jersey and California at 3.97% and 3.71% respectively. Among the states in the list, Washington reported the lowest forbearance rates at 2.17%. 

Chart: Forbearance Rate of Housing Loans the U.S. 2021, by State

One percent represents a significant reduction in your rate, which could result in significant monthly savings. For example, if you have a $250,000 loan and your interest rate drops from 3.75 percent to 2.75 percent, you could save $250 per month, which is nearly a 20% reduction in your monthly payments.

However, you should always compare your current mortgage terms to any new deal. Remember to account for closing costs and any fees in your calculations. For example, if you are locked into a deal and must pay an early repayment fee, the potential savings may be significantly offset.

A cash out refinance replaces an existing mortgage with a larger, new mortgage, allowing you to access a large sum of money at a low interest rate. This is a potentially less expensive way to borrow money, and you can spend it however you want.

If you don't want to deal with two monthly payments, as you would with a mortgage and a home equity loan, this can be a good option.

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