If you’re a homeowner with an existing mortgage, you might think you’re all set. But just because you have a mortgage locked in doesn’t necessarily mean it’s the best mortgage for your situation.
Refinancing is a cost-effective and logical option in many cases, particularly in a market with historically low interest rates.
What Does it Mean to Refinance?
Refinancing is essentially the process of replacing your existing mortgage on a property with another mortgage that has different and more advantageous terms.
There are a variety of reasons to refinance – and we’ll discuss many of them here in this article – but it’s almost always used as a way to save money. Sometimes those savings come upfront, while other times the savings are gradually realized several years down the road.
The refinancing process isn’t overly complicated in most scenarios, but it does require some intentionality. The first step is to see if you qualify. To do this, you’ll need to meet a few basic requirements.
- Original mortgage. Every lender will have their own requirements, but most will want proof that you’ve maintained your original mortgage for at least 12 months before they’ll even think about refinancing. They want to know that you’re capable of paying the current mortgage as-is before putting you into another one (even if it’s more favorable).
- Minimum equity threshold. Lenders always want the homeowner to have some skin in the game. If you can show at least 10 to 20 percent equity in the home, you’ll stand a better chance of getting competitive refinancing options.
- Current income. You have to remember that refinancing is really just a fancy term for taking on a new mortgage and using it to pay off your existing one. In other words, you’ll need to go through much of the same due diligence and underwriting processes that you went through to obtain the original mortgage. This includes an analysis of your income, debt-to-income ratio, etc.
- Credit score. A low credit score will result in a higher rate, while a high credit score will open the door for more favorable rates. Do your best to boost your rate in the months leading up to a potential refinance.
These requirements vary based on the lender and your individual circumstances, but there’s generally an expectation that you meet certain requirements. Keep these factors in mind as you explore this process in further detail.
4 Times Refinancing Makes Sense
Thanks to simple online refinancing tools that make it easy to shop rates and quickly calculate both the short-term and long-term costs, refinancing your mortgage is always an option.
However, there are certain circumstances where it makes more sense than others. It’s up to you to know when to pull the trigger and when to stay put.
Here are a few situations where refinancing is a logical option worthy of further investigation:
1. You Have a Very High Interest Rate
A high interest rate loan is the most obvious reason to refinance. If you obtained your mortgage at a time when rates were higher than they are today – or if you had challenging financial circumstances that prevented you from getting a favorable rate – refinancing could save you a decent amount on your monthly payment. (Not to mention significant interest savings over the life of your loan.)
The general rule of thumb is that you should refinance if you’re able to reduce your interest rate by at least 2 percent. However, in some situations, the ability to lower your interest rate by a single percentage point is enough to justify a refinance.
When refinancing to lower a high interest rate, make sure you also consider the long-term impact and your time horizon of ownership. Refinancing basically resets the payment process. So while you may lower your interest rate, you’re also slowing down the rate at which you’re able to build equity. And if you’re also extending the length of the mortgage, you could ultimately pay more over the life of the loan. Just keep these factors in mind! There is also the option to pay down your mortgage early.
2. You’re Currently in an Adjustable Rate Mortgage (ARM)
Adjustable rate mortgages (ARMs) are very attractive to first-time homebuyers and other individuals who want a low rate (but may not otherwise qualify for a low rate on a traditional loan). But as time passes, many homeowners become leery of getting stuck with an adjustable rate – particularly when interest rates are low and they have nowhere to go but up.
With an ARM loan, the homeowner carries all of the risk of rising interest rates. And though there are rules and limitations on how and when a lender can increase your rate, there’s always the risk that rates rise and you get stuck in a high-interest environment.
In many cases, refinancing to a fixed-rate mortgage is a smart move. It provides some stability and transfers that “risk” back to the lender. If nothing else, it gives you peace of mind and predictability with your finances.
3. Your Mortgage is More Than 15 Years
Some will disagree with this, but if you currently have a 30-year mortgage, refinancing to a 15-year can save you a significant amount of money in the long run.
In some cases, refinancing from a 30-year to a 15-year will lower your interest rate while simultaneously increasing your monthly payment. That’s because you’re squeezing the loan repayment into a smaller period of time. If you have the cash flow to deal with an increase in monthly payments and plan to be in the house for a long period of time, this works out as a net positive.
In other cases, you might be able to refinance from a high-interest 30-year loan to a lower-interest 15-year loan and still enjoy roughly the same monthly payment. This is the best-case scenario, as it allows you to save now and later.
4. You Need Equity to Consolidate Debt
If you have a major expense or lots of “bad” debt to your name, refinancing and tapping some of your equity could be a choice worth considering. This option is admittedly a risky one for many families but does have its place in the refinancing discussion.
The basic idea with this approach is that you refinance. Also, you simultaneously pull out some of the equity that’s currently in your home. You then use that equity to pay off a higher-interest loan and/or pay for something that would otherwise require you to take a high-interest loan (like a vehicle, upcoming medical bill, or child’s college education). While risky, some people even refinance to fund a business.
This method is often referred to as a cash-out refinance. If you go this route, you should know that many lenders will charge a higher interest rate.
How to Refinance Your Mortgage
Depending on your circumstances, now may be as good a time as any to begin the process of refinancing your mortgage. The question is, where do you start?
Here are a few steps to consider:
- Set a goal. Get clear on what your specific refinancing goal is. Are you trying to reduce the amount of your monthly payments? Is your primary goal to shorten the loan? In addition, do you want to save on the amount of interest you pay over the life of the loan? Do you want to eliminate FHA mortgage insurance?
- Shop for rates. Thankfully, it’s super easy to shop around for rates and figure out what’s available on the open market. However, we recommend looking at more than just rates. Consider fees and closing costs as well.
- Engage multiple lenders. To get a true feel for what sort of loan you qualify for, speak to a minimum of three lenders. (When doing so, try to submit all applications within a two-week window. This minimizes the impact on your credit score.)
- Compare loan estimate docs. Every mortgage provider is required to provide you with a standardized loan estimate document that allows you to compare loans and gives you a clear idea of how much cash you’ll need at closing.
- Lock your rate. Once you decide which refinance offer you want to go with, lock your rate in. This ensures that your rate will stay the same regardless of what happens in the market.
- Close. Be prepared for a closing process that’s very similar to the process you used to originally close on the house. Assuming everything has gone smoothly up until this point, it should be a fairly swift process.
Refinancing to save money is the case in 90 percent of situations. If you’re in this boat as well, just make sure you have a plan for how you’ll use that money. It’s easy to go into the refinancing process with a plan to use your $400 in monthly savings. Additionally, you can use it to invest and build up your retirement nest egg. Just try not to squander the money on frivolous purchases. This ultimately defeats the purpose of refinancing in the first place.
There isn’t necessarily a right or wrong way to use the money you free up in your monthly budget. However, there should be a plan. Without one, the monthly savings will disappear and you’ll be left without a whole lot to show for it.
Is Refinancing Right for You?
As this article proves, there are a number of scenarios where refinancing is the right thing to do. Now it’s up to you to make sure you do your due diligence and make a sound financial decision. Essentially, you want this decision to benefit your family and finances for years to come. It’s okay to be unsure about how to proceed. Just remember that it costs nothing to shop around for rates and see what your options are.