Ramit Sethi
Key Takeaways
- Refinancing can save money if you can take advantage of lower interest rates, which makes your mortgage debt less expensive to carry.
- There’s more than one way to refinance, so choose the solution that complements your finances.
- Refinancing can eliminate extra costs over the lifetime of your home loan like private mortgage insurance.
Although the pandemic has caused economic turmoil, it’s also resulted in at least one bright spot: interest rates are dropping to historic lows. Lower interest rates can mean lower monthly mortgage payments or better loan terms, which is especially helpful for individuals who’ve lost their jobs, had hours cut, or otherwise felt the impact of a worldwide health crisis.
But there’s more to refinancing than waltzing into your local bank and demanding a new loan. Understanding the different forms of refinancing can guide you to a decision that makes sense for you.
What Does Refinancing Your Home Mortgage Mean?
Refinancing your mortgage means you replace your existing home loan with a new one. Homeowners can use home loan refinancing to leverage lower interest rates, restructure their mortgages, or tap into their home equity.
When Should I Consider Refinancing My Mortgage?
- To leverage a lower interest rate: You can lower your monthly mortgage payments if you can secure a lower interest rate, which makes your debt less expensive to carry over time.
- If you can recoup the costs: Refinancin’ ain’t free, so you’ll have to whip out a calculator to confirm that you reach a break-even point relatively early on in your new loan. At first, your loan will be more expensive because of the closing costs for the new mortgage, but you’ll save money later in the form of less interest.
- If you want to reduce your loan term: Homeowners often opt for a 30-year mortgage to spread out payments. This is a double-edged sword because it also means that you’re paying more in interest plus other potential expenses like insurance. By reducing your loan to a 15-year term, you can pay more cash toward the principal.
- If you want to transition from an ARM to fixed: If you’re in an adjustable-rate mortgage (ARM), your interest rate stays the same for an initial period, but then changes every year for the life of the loan, according to an interest rate index. Worried about your interest rate going up? If you’ll be in your home for the long haul, it might make sense to restructure into a fixed-rate mortgage.
- To use a cash-out refinance: For homeowners with a substantial amount of equity (over 20%) in their homes, there’s an opportunity to refinance and “cash-out” the difference between your old home loan and your new one. This cash is free to use for home improvement projects etc. You can think of cash-out refinancing as a way to both refinance your mortgage and borrow money, simultaneously.
- To get rid of mortgage insurance: Many lenders require at least a 20% down payment if you want to avoid mortgage insurance. If you’re still paying mortgage insurance, refinancing is a way to eliminate it.
What Are the Costs of Refinancing?
Refinancing is Latin for “new loan.”
Okay, it’s not, but refinancing still means that a new loan is created to replace your old one. Remember all those fees and expenses you had to pay for your first home loan? Unfortunately, those same costs apply.
Fees vary lender to lender, but you may have to pay fees for the initial application, loan origination, legal reviews, title insurance, and title searches. All in all, these fees and costs usually sit between 3% and 5% of the total loan.
Okay, How Do I Refinance?
Step 1: Know why you’re refinancing
Do you want to restructure your ARM into a fixed-rate loan? Do you want to shorten your loan duration? It’s essential to nail down exactly why you want to refinance your mortgage, so you can approach the refinancing process with a specific goal in mind.
Step 2: Take your financial temperature
Just like your original home loan, your new mortgage requires approval. Do you have a good to excellent credit score and a low debt-to-income ratio? The better your finances, the better your potential loan terms.
If your credit score could use a little work or you have lots of outstanding loans you can pay off, it’s in your best interest to work on improving it before applying for a new loan.
Step 3: Calculate how much home equity you’ve built up
Home equity is the difference between your property’s value and how much you owe the mortgage lender. So, let’s say your home is worth $500,000, and you owe $300,000 on the loan. Your home equity would be $200,000. Figuring out your home equity will tell you if you can avoid getting private mortgage insurance and other fees.
Note: If you have more than 20% equity in your home, you’ll be charged with fewer fees and be eligible for better loan terms. But you can still refinance if you have at least 5% equity.
Step 4: Get quotes from lenders
When you’re shopping for clothes, you probably don’t take home the first thing you pick up on the sales rack. You likely try on a few clothing combos, decide those horizontal stripes are unflattering and put a few pieces back before ending up at the register. The same process should apply to your refinancing… Minus the horizontal stripes.
Approach multiple lenders to get a variety of quotes. Make sure you look beyond interest rates when evaluating your quotes—the fees and other costs are also important to consider.
Step 5: Gather your paperwork
Have you ever had to give a speech without your notecards there to guide you? Although winging it can sometimes result in success for the lucky few, you’ll have a lot more success if you prepare. You shouldn’t “wing” your refinancing, either.
Gather appropriate tax documents, pay stubs, IDs, and all the other paperwork your lender needs for the loan approval process. In some cases, you’ll also need to prepare for an appraisal—but not all lenders require this step.
Step 6: Prepare for closing
Like your first home loan, you’ll be on the hook for closing costs. Lenders will give you the closing disclosure and loan estimate that details how much cash you’ll need to close on your new loan.
Step 7: Pay your loan and settle in
Ask your lender about autopay discounts and make sure you keep track of your loan payments. Make copies of your paperwork and review your statements regularly.
Your Home, For a Little Cheaper
Refinancing isn’t for everyone, but it’s worth your time to look into your options when interest rates drop or if your current mortgage terms aren’t ideal. The pandemic has delivered a slew of unfortunate news, but for some homeowners, it can make a mortgage debt less expensive to carry.
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