Helping you understand how and why to refinance your mortgage
Considering a mortgage refinance? With rates as low as they are, it may sound appealing and can, in fact, save thousands of dollars in interest. But refinancing isn’t necessarily for everyone, and if you’re further along in your mortgage it may be financially smarter for you to stay with that loan.
Our Guide to Refinancing Your Mortgage offers up the top 4 things to know about mortgage refis and will help you determine if refinancing is right for you.
- What is a mortgage refinance?
- When and why should I refinance my mortgage?
- Can I refinance if I have a second mortgage?
- Is a refinance worth it?
In a nutshell, refinancing your mortgage means you are getting another mortgage to replace your original one. This is not the same as having a second mortgage; your refinanced mortgage is replacing your original mortgage, not being added as a second lien.
What is a lien?
A lien is what gives your financial institution a legal interest in the property (your home or car, for example) they have financed for you. The lien provides security to your financial institution in the event you stop making payments. Once your loan is paid in full, the lien is released.
People refinance their mortgage for a variety of reasons, but refis are most commonly used to lower the interest rate or improve the term (length) of an existing mortgage. Sometimes, people opt for a cash-out refinance to fund large purchases or pay off debt.
When you apply for a refi, the process will be virtually the same as it was when you applied for your original mortgage. There will be an application fee and closing costs, and the lender will require an appraisal to determine how much they can lend. These fees will be an important deciding factor as to whether a refinance makes sense for you. We’ll cover this when we talk about breaking even.
There are three main reasons to refinance your mortgage: to secure a better rate and term, to get cash back, also known as a cash-out refi, or to put more cash towards your mortgage, also known as a cash-in.
Reason 1: Refi to change the rate or term of your mortgage
If interest rates have dropped since you closed on your mortgage, and your credit is as good or better, refinancing your mortgage could save you thousands in interest charges. This is especially true if your mortgage is fairly new; because a mortgage refinance is essentially re-doing your original mortgage, your amortization starts all over.
Early in your mortgage, the bulk of your monthly payment goes towards interest and as your mortgage ages, that split shifts and more and more of your monthly payment goes towards the principal amount. If you’re still early in your mortgage, you aren’t losing as much paid interest as you would if you refinanced later in your mortgage. This is not to say, though, that a refi doesn’t make sense later in your mortgage. It does mean that just because you’ll get a lower rate, though, it doesn’t necessarily mean a refi is the smartest financial move.
Use our refinance calculator to determine if a mortgage refi makes sense for you.
Lowering the interest on your mortgage by even just 1% can end up saving you money. Let’s say you’re one year into a 30-year mortgage for $100,000 and are paying 6% interest. Over the life of your mortgage, you’ll pay just shy of $110,000 in interest. If you refinance at 5%, you lower that total interest paid to about $95,500.
Another reason to consider refinancing your mortgage is the ability to own your home sooner. If interest rates have dropped significantly from when you closed on your mortgage, you may be able to shorten the term of your mortgage, say from 30 to 15 years, and pay it off sooner with only slightly higher monthly payments.
Refinancing your mortgage may also make sense if you’re in an ARM (adjustable-rate mortgage). Very often, people will opt for ARMs because the initial interest rate is low. If rates have dropped, though, it may make sense to refinance into a fixed-rate mortgage and avoid potentially higher rates in the future.
On the flip side, you may be in a fixed-rate mortgage and want to refinance to take advantage of the lower initial rates of an ARM. If you know you will be able to pay the loan off within a certain amount of time, or that you will be selling the house before your rate adjusts upwards, this may be a smart financial move.
Reason 2: Refi to cash out
A cash-out mortgage does exactly what it says: provides you with cash upon closing. Essentially, you’re going to refinance for an amount that is more than what you owe based on the amount of equity you’ve built up in your home. Typically, you’ll need at least 20% equity in your home to qualify for a cash-out refi. From the extra amount you “add” to your mortgage, you will pay the closing costs of the refinance and then have a remainder lump sum amount.
Remaining Mortgage Balance: $100,000
Refinance Amount: $150,000
Closing Costs: $6,000 (estimated, closing costs vary)
Cash out Amount: $44,000
You can use the proceeds of a cash-out refinance for major expenses like home improvements, medical bills, or college costs, or to pay off higher-rate credit card debts. If you plan on using your cash-out to pay off other debts, it will be critical to commit to smart spending going forward; building your credit card debt back up after refinancing your mortgage to pay it off will put you in a precarious financial position. Also, keep in mind that using a cash-out refi to pay off debts means you’re extending the life of those debts for up to 30 years. Would it be faster to pay them down another way? If so, a cash-out refi may not be the best option for you.
Click for more information on debt consolidation.
Reason 3: Cash-in refi to lower your mortgage amount
A cash-in refinance is the exact opposite of a cash-out: instead of getting money from your refi, you’re putting more money into your mortgage to lower the overall amount you’re financing. The main reason people pursue this type of refinancing is if they owe more money on their home than it’s worth. If you owe $215,000 on a home that’s worth $200,000, you won’t qualify for a traditional mortgage refi because lenders will only lend up to a certain percentage of the home’s value (typically 80%).
Loan to Value
Financial institutions will often base their refinance lending limits on what is known as a loan to value ratio (LTV). Simply stated, LTV is the percentage of your home’s value that you can borrow.
Let’s say interest rates have dropped and you’d like to refi. To be able to refinance your mortgage in this situation, you have to lower the overall amount you owe to conform with your lender’s loan-to-value (LTV) policy. This can be done if you have access to a significant amount of cash, but it’s important to keep in mind that you shouldn’t deplete your savings, retirement, or emergency fund to do so. If you find yourself considering a cash-in refinance, talk to your financial institution to weigh all of your options.
If you have a second mortgage or a second lien in the form of a Home Equity Loan or Line of Credit, you will need to have a careful discussion with your financial institution before applying to refinance your mortgage. Before you refinance your mortgage, any secondary liens are subordinate to your mortgage. This means that, in the event you foreclose on your home, any proceeds from the foreclosure would satisfy your primary mortgage first. If there is anything left, the subordinate lienholder receives those funds.
Once you refinance, though, your secondary lien (your second mortgage or home equity loan) will move into the primary position. Your refinance lender may object to this as they will likely want to maintain the primary lien position. They may require the secondary lien holder to be moved back into a subordinate position to ensure that their interests in the property are satisfied first. This process may take some back and forth with your lenders. It’s best to talk to the financial institution that holds your second mortgage or home equity loan before you even apply for a refinance to determine how willing they are to stay in the subordinate position.
In general, if you can lower your interest rate by at least 0.75%, and you’re still within the first few years of your mortgage, a refi should be worth it.
How do you know if the savings you may realize with a mortgage refi are actually worth it? In a very general sense, if you’re within the first few years of your mortgage and can lower your interest rate by at least 0.75%, a refinance may make sense.
To help you figure out if a refi makes sense for you, let’s take a look at calculating your break-even point.
What is my break-even point?
You are going to want to know when you will actually start saving money with your mortgage refinance. This is known as your break-even point. It can very often take years to recoup the costs associated with refinancing and going through the process of calculating your break-even point can help you see whether or not those costs are worth it.
How do I calculate my break-even point?
Your break-even analysis is relatively simple to complete. First, you’ll need to know how much your refinance is going to cost. The fees associated will include:
- Application fee
- Appraisal fee
- Title fee
- Escrow charges
- Third-party fees (credit report, attorney fees, etc.)
Your lender will provide you with an estimate of these costs when you apply for your refinance.
You’ll also need to know how much you’ll be saving per month with a refi. You can use our refinance calculator to estimate your new payment and thus calculate your savings. Then, divide your total costs by your total savings. The result is the number of months it will take for you to break-even and recoup the costs of your refi.
For example, let’s say the total fees and closing costs for your refinance will be $4,000 and you’ll be saving $150 per month. Your break-even point is 26.7, meaning it will take you about 27 months to recoup the expenses of your refi.
Refinancing your mortgage is a major financial decision. It can definitely help you save money under the right circumstances, but rushing into it or failing to understand the costs and risks associated with refis makes those savings irrelevant. Talk to your lender about the process and whether it might be the right fit for you.
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