Refinancing is the process of replacing an existing mortgage with a new one by changing the terms of the current loan. Typically, homeowners consider refinancing their mortgage for a few reasons, including:
- Reducing monthly mortgage payments;
- Obtaining a lower interest rate;
- Switching mortgage lenders; or
- Shortening the term of the original mortgage.
As mortgage rates continue to drop, nearly 20 million homeowners could benefit from refinancing, according to a study by Black Knight.
Source: Black Knight
Is Refinancing Worth It?
However, refinancing a mortgage is not always a smart financial decision. You need to make sure that refinancing will save you money in the long run. Determining whether refinancing your mortgage makes sense in your particular situation comes down to four questions:
- How much money will you save by refinancing?
- How much equity do you have in the home?
- How long do you plan to stay in the house?
- What is your overall financial situation?
Do You Qualify to Refinance Your Mortgage?
If you’re wondering, “Is now a good time to refinance my mortgage?” you should also ask yourself, “Will I qualify to refinance?”
Even if refinancing your mortgage is a wise financial move in your situation, you will still need to qualify. When reviewing your application to refinance, the lender will consider the following factors:
- Whether you are making timely payments on your original mortgage;
- Your credit score and creditworthiness;
- The amount of equity in your home; and
- Your income.
Note: Your mortgage refinance rate will be primarily based on your credit score and the amount of equity in the home.
When to Refinance a Mortgage
You need to make sure that you’re refinancing for the right reasons. As a rule of thumb, homeowners benefit from refinancing their mortgage in the following situations:
1. You want to switch to an adjustable-rate mortgage (ARM) or fixed-rate loan
Typically, adjustable-rate mortgages (ARMs) offer lower rates and are easier to qualify for than fixed-rate mortgages. The downside of an ARM is that the interest rate resets periodically (often, on a yearly or monthly basis), which could result in rates and payments rising substantially over time.
For this reason, many homeowners choose to refinance their mortgage to switch from an ARM to a fixed rate. However, in some cases, it’s more beneficial to convert from a fixed-rate to an adjustable-rate mortgage, especially when mortgage interest rates are going down or when the homeowner is planning to move to a new home in the foreseeable future.
2. You want to pay off the loan faster
If your current mortgage is 30 years, you could benefit from refinancing to get a 15-year mortgage. As a result, you would pay off the loan much faster and end up paying less interest over time. However, you need to make sure that you can afford the monthly payments after refinancing.
3. You want to lower your interest rate
If your original mortgage has a higher interest rate than those currently being offered, consider refinancing. In this situation, refinancing your mortgage could be a sound financial decision to lower your interest rate or shorter your payment term.
As a rule of thumb, refinancing makes sense only when mortgage rates are lower than your current rate by 1% or more.
4. You want to tap into home equity
Most lenders require borrowers to keep at least 20% equity in the home. Home equity is the difference between the home’s appraised value and how much the borrower still owes their lender.
Thus, when you refinance to borrow more than you owe on your original mortgage, the lender will give you a check for the difference, which is also known as a cash-out refinance.
How Much Does It Cost to Refinance Your Mortgage?
Refinancing your mortgage can cost from 2% to 5% of the loan amount in closing costs. For example, if you borrow $100,000 and closing costs are 4% of that, you would owe $4,000 at closing. In addition to that, you will have to pay application and appraisal fees, among other expenses. Also, there is a new refinancing fee that kicked in on December 1, 2020.
According to Forbes, the so-called “adverse market refinance fee” is 0.5% charged to refinances sold to Fannie Mae or Freddie Mac, which buy the vast majority of U.S. mortgages. The fee doesn’t apply to loans valued at $125,000 or less. FHA, VA, and USDA loans are also cleared from the new refinancing fee.
You could save money by refinancing your mortgage, but you could also end up paying more in the long run. For this reason, it is important to determine whether refinancing is a wise financial move in your particular situation.