Back to Basics: Mortgage Refinancing

Mortgage Refinancing

Back to Basics: Mortgage Refinancing

* This article was originally published on November 13, 2019. It has been updated for 2020.

Have you heard? The Federal Reserve is planning to keep interest rates around 0% for the next couple of years. 

Moves like these can sometimes affect interest rates for many loans, including home mortgages. With the average mortgage rate hovering just above 3% APR, if your mortgage rate is considerably higher, you may have an opportunity to save money now and in the future by refinancing.

Refinancing a mortgage is a means to pay off an existing loan with a new — and ideally better — loan, as measured by a new rate and new terms. Does your mortgage current situation warrant a look at refinancing? Check out these pros and cons to see if it might.

Mortgage Refinancing Benefits

For many homeowners, refinancing their homes can provide them with several benefits that make the process worth the effort. Do any of the following reasons to refinance your home sound beneficial?

Get a better interest rate — This is the most common reason for a homeowner to refinance a mortgage. If the average interest rate is lower than your current rate, you may stand a good chance of securing new terms. You might also save money on interest payments as a result of refinancing.

Reduce monthly payments — If you’re struggling with your monthly budget, refinancing your mortgage could help. A refinanced loan can equate to lower monthly payments and give you more financial wiggle room.

Shorten loan length — When you first purchased your home, a 30-year mortgage may have been the better option. But if a 15-year loan now makes more sense, refinancing could provide you with more beneficial terms.

Switch loan type — If you have a fixed-rate mortgage, refinancing to one with an adjustable rate could help you take advantage of lower rates, especially if you plan to sell sooner than later. On the flipside, switching from an adjustable-rate mortgage that is adjusting higher to one with a lower fixed rate could help reduce stress and the amount you’re paying in interest.

Cash out your equity — Want to tap into your home’s equity to consolidate loans or pay off debt? A cash-out refinance could get you the cash you need at a lower rate than credit cards or personal loans.

When Refinancing May Not Be for You

Refinancing isn’t always the best path to take as a homeowner. Several considerations for certain situations warrant thinking twice before refinancing.

Extended loans — Refinancing when you’re past a certain point in the life of your loan can be risky. You could end up paying for another 30 years, which is the average life of a mortgage.

Upfront costs — Over time, refinancing can save a homebuyer thousands of dollars. But there are also upfront costs to consider, including application fees and closing costs. 

Higher rates for minimal rewards — Refinancing doesn’t guarantee a lower rate or big savings. In some situations, exhaustive efforts provide only minuscule results in real APR terms.

If you have a young mortgage with a high interest rate, these potential pitfalls shouldn’t hold you back. As long as you have the budget to absorb the initial costs, you might seriously consider exploring your refinance options. You could even save money and positively affect your financial future. 

Mortgage Refinancing in 9 Simple Steps

In 2018, 36% of all mortgages issued were refinance loans. So, if you’re considering taking the plunge, you won’t be swimming alone. And if you’re thinking about diving in, you can follow our steps below. They can help you get started on the path to better understanding your current mortgage as well as refinancing rates and terms.

1. Examine your mortgage statement.

Your mortgage statement is full of information that can help you decide if refinancing is right for you.

How much of the original principal loan amount have you already paid?
How much in interest?
What’s your current mortgage rate?

Keep this information easily accessible as you move through the refinancing process.

If your loan is still young, you’ll notice high percentages of your monthly payments going to interest. As your loan ages, higher percentages of your payments will go directly to paying down the principal of the loan. This is why it rarely makes sense to refinance older loans.

2. Get to know your debt-to-income ratio.

This personal finance measure compares your monthly debt payments to your monthly gross income. Lenders prefer loan applicants have a debt-to-income ratio that is less than 36%, including a mortgage payment. For example, if your monthly gross income is $7,500, a lender is unlikely to approve a mortgage payment higher than $2,700.

What’s your debt-to-income ratio, including your current mortgage payments, today? Compare your current debt-to-income ratio to what it would be if you refinanced. Is there a drastic difference? Don’t be afraid to set your own debt-to-income ratio to base your mortgage payments on if you’re more comfortable with a lower percentage. Refinancing could help you achieve your ideal ratio.

3. Check your credit score.

Your credit score will have a direct effect on refinancing rates available to you. As you may have already assumed, the better your credit score, the better chance you have of securing a low mortgage rate.

If possible, compare your current credit score to the score you had when you secured your first mortgage. Has it improved, stayed the same, or headed south? If your credit score has gotten worse, you may want to focus on improving it before applying to refinance your loan. Keep in mind that the minimum credit score required to refinance depends on the type of loan you’re seeking. You may still be able to be approved with a score as low as 500.

4. Rate your new rate.

If you pressed forward and applied to refinance your mortgage loan, how does the new rate you were offered compare to your current rate? If you’re not sure how to calculate the difference, you can use a mortgage refinance calculator.

Here’s a hypothetical scenario to consider: Let’s say your original loan had a principal of $300,000 with a rate of 5.125% and a 30-year term. After paying five years’ worth of mortgage payments, you refinance and secure a rate of 4% with a 30-year term. Your new payments will save you $314 a month and nearly $17,000 in interest over the life of your refinance loan. Can your new rate deliver similar — or better — results?

5. Think in terms of your new term.

The previous example showed the difference between two loans with different rates but similar terms. What happens when your new loan has different repayment stipulations?

If we take the same amounts and change the refinanced loan to a 15-year term rather than a 30, we can see significant changes. While the homeowner will save over $36,000 in interest over the life of the loan and pay it off sooner, monthly payments increase by $413. If you find yourself in this situation, you’ll have to decide if it’s more important to save money as a whole or minimize your monthly payments to better accommodate your budget.

6. Close in on the closing costs.

Mortgage refinancing closing costs can take a homeowner by surprise. Unfortunately, they’re a necessary evil of the process. Closing costs on a refinanced mortgage in the U.S. average $4,345. Rolling these into the loan, as some lenders allow, can eat away at the benefits of refinancing, so be careful there.

It’s also important to consider other types of fees. These include the home appraisal fee, application fee, credit report fee, and loan origination fee, among others.

7. Learn how refinancing could impact your finances.

Any change can create a ripple effect in your financial pool. Understanding if it will be a gentle wave or a monstrous swell is important. To get a better idea of how refinancing could impact yours, you can calculate your break-even point.

 I suggest using a break-even calculator, as there are many factors to consider. But here’s an example: Let’s go back to our original loan of $300,000. If the home’s appraised value comes in at $350,000 and you secure a new loan at 4% for 30 years, it will take approximately 32 months to break even after closing costs and fees.

8. Understand the potential tax ramifications.

Refinancing can change some things on your tax return. While mortgage interest is tax deductible, you should be aware of some fine print. The Tax Cuts and Jobs Act dropped the size of a loan on which you can deduct interest from $1 million to $750,000 for loans made after Dec. 15, 2017. Also, only interest on a loan used to purchase, construct, or make substantial improvements to your home qualify for the deduction — so if you roll anything else into your refinance, a portion of the interest may not be deductible.

Even if your home is worth less than a million or three-quarters of a million dollars, refinancing can still affect your tax return. If you secure a lower interest rate, you will be paying less interest overall, meaning you won’t be able to deduct as much interest when tax time rolls around. But you shouldn’t necessarily let this tax-tail wag the dog.

9. Is it worth it, in both financial and non-financial terms, to refinance?

On average, it takes 44 days from application to closing to refinance a loan. The process can eat up your free time, cause stress, and bring on unpleasant emotions.

Consider all the pros and cons before committing to a refinance. What’s your personal break-even point? In other words, how much do you need to save for the process to be worth taking on?

In many situations, refinancing a home can be a resourceful option. Refinancing a mortgage loan can save money, alleviate stress, and set the foundation for a brighter financial future.

However, refinancing can also be intimidating — especially the first time around. If you have questions, concerns, or are hesitant on the best next step for your unique situation, don’t hesitate to reach out for help. Working with your financial professional can help you gain insights into and confidence for your refinance journey.

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Jason Speciner
Jason Speciner
jason@fpfoco.com

Jason Speciner is a CERTIFIED FINANCIAL PLANNER™ professional, an Enrolled Agent, and the founder of fee-only firm Financial Planning Fort Collins. He is also a member of the National Association of Personal Financial Advisors (NAPFA), Financial Planning Association (FPA), and XY Planning Network. Since 2004, he has served clients of all ages and backgrounds with unique experience working with members of generations X and Y. To learn more, check out Jason's blogs and see the media he's been featured in.