Mortgage refinancing is the process of replacing your current loan with a new one. Most people refinance to lower their interest rate, lower their monthly payment, or – in the case of a cash-out refinance – to tap their home equity. Knowing when to refinance your mortgage will help you refinance effectively.
Know Why You Want to Refinance
Refinancing can help you achieve financial goals, but it comes at a cost. Refinancing your mortgage will involve closing costs, which may cost up to 6% of your principal amount.
Let’s see when it makes sense to begin this process.
The first and most important step toward making refinancing work is knowing what you want to accomplish. If your goals are clear, you have a solid basis for deciding whether a refinancing option will meet your needs.
These are some of the most common reasons to refinance.
Lower Interest Rates
The best reason to refinance mortgages is to lower interest rates on your current loan. A fall in interest rates increases the rate at which homeowners can build home equity and increase overall savings.
The monthly payment for a 30-year-old mortgage priced at $100,000 will amount to $568 at an interest rate of 5.5%.
However, if the interest rate falls to 4.1%, your monthly mortgage payment will reduce to almost $475.
Mortgage rates are currently rising steeply after a long period near record lows: at this writing, the average rate for a 30 year fixed-rate mortgage is 6.94%, the highest it’s been since 2002. That could make it difficult to find a new loan at a better rate than your old one. It could still be possible if your credit score has improved dramatically since you took out your existing mortgage.
Change Your Loan Term
Homeowners might want to change their loan terms for a variety of reasons. If you struggle to make mortgage payments, you can increase your loan term by refinancing the loan, resulting in lower monthly payouts. You can refinance a 20-year mortgage to a 30-year one and make lower monthly mortgage payments.
A longer loan term will mean higher total interest expense, but if you’re having trouble making your payments, it is still a legitimate option…
Alternatively, suppose you are generating enough cash flow to meet your monthly expenses and investments. In that case, it might be time to shorten your mortgage term. You’ll build equity faster and reduce your total interest expense.
This is also a viable move, but you’ll have to be sure that you have the means to make those higher payments, even if unexpected events occur.
Tap Your Home Equity
A cash-out refinance is a way to gain access to a portion of your home’s value to use for other purposes. You will take out a refinancing loan for more than the value of your mortgage and take the difference in cash.
If your home is worth $400,000 and your mortgage balance is $200,000, you could take a refinancing mortgage of $250,000, and you’d have $50,000 in cash.
The downside of this is that your new mortgage will be larger than your old mortgage balance.
The upside is that – using the above example – you are effectively borrowing $50,000 for a lower rate than you could get anywhere else. If you were considering a debt consolidation loan, for example, a cash-out refinance would allow you to consolidate debts at a lower rate than you’d get from an unsecured personal loan.
Of course, you’d have to be very careful to put that money to a good purpose, and you’d have to be sure that you have the capacity to pay that new, larger mortgage.
The proceeds of a cash-out refinance can be used in any way you like, but remember that this money is borrowed, not given. Use it wisely, or you’re likely to find yourself with bigger problems down the line.
It’s generally not a good idea to use a cash-out refinance unless you can get a better interest rate than you had on your previous mortgage. If you can’t, the cost is likely to be too high.
Change Your Mortgage Type
Another reason to refinance your mortgage is to convert the loan from a fixed-rate mortgage to an adjustable-rate mortgage (ARM) or vice versa. ARMs generally have lower interest rates than fixed-rate mortgages. But quarterly or yearly adjustments may easily result in rate increases over time, making ARMs more expensive.
So, it makes sense to convert the loan to a fixed-rate mortgage to lower interest rates and protect yourself from any fluctuations in future yields. On the other hand, if interest rates are falling, you can convert an ARM into a fixed-rate mortgage.
Remove a Cosigner
Imagine that you took out a mortgage ten years ago and asked your parents to cosign because you couldn’t get a good enough rate on your own.
Ten years down the line, your credit is solid, you’re financially stable, and your parents want to take out a new mortgage of their own. That cosigned loan could push their debt-to-income ratio to a point that scares lenders away.
You can refinance the mortgage on your own and set your cosigners free from their obligation.
Should You Refinance Your Mortgage?
Once you know what you hope to achieve from refinancing, you can look for a loan that will meet your objectives.
You’ll shop for a refinancing loan in much the same way that you shopped for a mortgage. The offers you get will depend heavily on your credit score, your debt-to-income ratio, and other measures of your creditworthiness.
It’s important to consider multiple offers. Borrowers who shop around get consistently better rates and terms than those who take the first offer they get.
Once you have several offers in hand, assess them to see if they will allow you to meet your goals. You don’t have to take any of them: sticking with your current mortgage is always an option. Remember to consider the closing costs in your calculation.
If you’re convinced that the best offer meets your needs and gives you what you want from refinancing, then it’s time to refinance your mortgage!