Should you refinance your mortgage?

We know what it’s like trying to buy a home that you’ve always dreamed of. When the opportunity comes, you’ll do just about anything to get approved on a mortgage. This sometimes means accepting terms that stretch you a little. Down the road you might look at those terms and begin to question whether or not you still like them, or if you might qualify for better ones.

It’s moments like this that lead us to the question if we should refinance our mortgage or not. That’s why we’re here to explain everything you need to know so you can make the right choice with confidence.

What does refinancing your mortgage mean?

Refinancing your mortgage simply means trading out your current mortgage for a new one. The reasons for doing this vary and what you end up with depends on what you’re trying to accomplish.

How does refinancing a mortgage work? The process is pretty simple and you should expect it to take around 30 to 45 days. Here are the steps:

1. Applying - you’ll need some documents like pay stubs, tax information, and bank statements
2. Receive loan estimate - within 3 days of receiving your application, the mortgage lender is required to provide a loan estimate, which breaks down the important aspects of the loan.
3. Underwriting - the lender looks into your information and decides on approval. They’ll have the home appraised and write up the contract during this stage.
4. Closing - once the lender has the contract ready, you’ll meet to sign all the closing documents

Now, when you go in to apply, it’s best to have an idea of what you are applying for. To help you out, here are common refinancing options to consider:

Rate and Term refinance (Traditional Refinance)

Simply put: refinancing your mortgage for a different term or interest rate. This is a very common reason for refinancing, especially when interest rates are lower than normal. Getting a lower interest rate is a great way to pay less monthly or in the long term for your home. Also, if you had a 30-year loan and would like to shorten the amount of time left, you could refinance to a 15-year mortgage. Alternatively, if you find you can no longer afford the payments on a 15-year mortgage, you could refinance for a longer term to get a more affordable payment.

Cash-Out refinance

This is when you take out a new mortgage for more than you owe on your current mortgage and pocket the difference. This gives you cash that can be used for anything from debt consolidation to home improvements.

Cash-In refinance

This is basically a traditional refinance with a focus on making a larger down payment and refinancing a smaller amount. This increases the amount of equity the borrower has in their home and can be a great option for people who are upside down on their home loans.

No-Closing-Cost refinance

This allows a person to refinance without paying the closing costs. Instead, the closing costs are rolled into a higher interest rate or the principal. This allows someone who needs to refinance the ability to do so without paying out of pocket or use the funds they saved for another purpose.

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Things to consider before choosing to refinance

Now you might have a better idea of what you’re looking to apply for after reading through those options, but there are still some things that can affect your decision. Before you go to apply, here’s what you need to consider.

Initial Cost

While refinancing could save you either monthly or in the long run, there are up-front costs you could end up paying in order to refinance your mortgage. While some lenders do offer a no-closing-cost refinance, this usually ends up giving a higher rate than you otherwise would have gotten if you paid the closing costs at the beginning.

In general, you can expect to pay 2% to 3% of the loan amount in closing costs to refinance. According to Marketwatch¹, the average cost of refinancing is around $5,000. This could be worth it depending on how long you plan to live in the home. Which brings us to the next thing to consider.

Break-Even point

The break-even point is where your choice to refinance your mortgage begins to save you money. If your purpose for refinancing is to save money, then this is important to calculate.

Say you plan on saving $100 a month on a new payment. You can divide the closing costs by the amount you’ll save each month to find the break even point. If you are paying $3,000 in closing costs, you’d divide it by the $100 in monthly savings to get 30 months before you end up breaking even. If you plan to live in the house longer than 2.5 years (30 months), you’ll end up saving on your monthly payment.

In some cases, the break-even may be harder to figure out, especially if you are doing a cash-out refinance, where the monthly mortgage payment could be more. You’d need to take into consideration what the money will be used for and how much that will save you.

Length of current mortgage

If you have 20+ years left on your current mortgage and would like to pay it off sooner, you could refinance for a shorter term to avoid paying more in interest in the long run.

If you don’t have much longer on your home loan, refinancing may not be the way to go and could lead to paying interest right away rather than paying down principal.

Current Interest Rates

There are two options when it comes to interest rates on a mortgage. An adjustable rate and a fixed rate.

An adjustable-rate mortgage (ARM) has a rate that changes after an initial period - usually 5, 7, or 10 years according to Rocket Mortgage². After that time, the rate changes each year to match rates across the market. If you have an adjustable-rate mortgage and you expect rates might go up, it may be best to refinance and get a fixed rate to avoid paying more interest in the future.

A fixed rate mortgage has a rate that is locked for the entire life of the loan. If you have a higher rate than normal and you expect rates will drop, it could be a good idea to refinance and get an adjustable rate. Alternatively, you could wait until rates drop and refinance with a lower fixed rate.

Equity in the home

Equity is essentially the amount of the home you own or the difference between how much it is worth and how much you owe. For example, if your home is worth $150,000 and you only have $100,000 remaining on the mortgage, then you have $50,000 in equity.

Refinancing is one way to access that equity and use it for another purpose - like consolidating debt or paying for home improvements. This is done by taking out a new mortgage for more than you owe on the house. The previous mortgage is paid off and the excess is yours to use.

How long you plan on living in the home

If you plan on living in your home for a long time, then refinancing to get better terms or pay it off sooner could be a good idea. If you plan on moving in the next few years, refinancing may not be worth the cost.

When should I refinance my mortgage

You may have already made the decision to refinance your mortgage, but is it the right time? To see what a refinanced mortgage would look like compared to your current mortgage check out this online calculator.

Here are a few more things to look for that might imply that it's the right time.

When interest rates are low

One of the best times to refinance is when interest rates are low. This is because the interest rate has a big impact on your monthly payment and how much you pay over the life of your loan. If interest rates are lower than what you have for your current mortgage, it could be the right time to refinance.

To see what a refinanced mortgage would look like compared to your current mortgage check out
this online calculator.

When Interest rates are expected to rise

If you have an adjustable-rate mortgage and rates are expected to go up, then it could be a good time to refinance to a fixed rate. This would help mitigate the risk of your monthly mortgage payment going up and paying more in interest.

When rates are expected to rise, many people also begin thinking about how they can consolidate debt. A cash-out refinance allows you to pay off other debts and basically lump them into your new mortgage. In the long run it may save you from paying way too much on high interest credit cards or debt.

When you’re having trouble making your payment

There are a few options if you are unable to make your monthly mortgage payments.

If rates are lower, you could possibly refinance and end up with a lower monthly payment, making it more affordable.

Refinancing could help you avoid paying Private Mortgage Insurance (PMI) if you have at least 20% equity in your home.³ Most mortgage lenders require a 20% downpayment to avoid PMI, so if you have 20% equity in the home, then refinancing could help.

If you have defaulted on your payment and you are looking at possibly foreclosing, then a short refinance may be an option. This is something that lenders will sometimes do to avoid the expense of foreclosure. In this instance, a lender may be willing to refinance for a lower amount, giving you a more affordable payment. It allows you to keep the home and they will still recoup most of the debt, rather than losing out on foreclosure.

For example, if you originally took out a mortgage for $150,000, but the value of your home dropped to $100,000 and you still owed $130,000 on it. If you are on the verge of foreclosure, they may refinance for the $100,000 value of the home and forgive the $30,000 difference. While this could help you keep the home, it would have a negative impact on your credit score, and it may not be something your mortgage lender is willing to do.

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How to qualify for refinancing

While it’s difficult to be sure that you will qualify for refinancing, there are some things you can look at to give yourself an idea. Here’s what the lender will look at when deciding on an approval

Credit score

As with a typical mortgage, your credit score will be considered when refinancing. Most lenders will require a credit score of 620 or higher for a refinance, however, this could change depending on the lender and the type of loan. It’s best to check with your lender before applying.

Home Equity

Lenders will consider how much equity you have in the home when looking at approval. This is especially true for a cash-out refinance. As we mentioned before, having 20% equity in your home is a great target to hit to refinance and avoid paying private mortgage insurance. If you have less than 20% equity, it could be made up for by a good credit score or a higher interest rate.

Debt to income ratio

Just like getting a mortgage to purchase a home, your lender will look at all the debts you currently have in order to see if you qualify. This helps them gauge your ability to pay off your loan.

Your DTI ratio is the amount of debt payments you have monthly, expressed as a percentage of your monthly income.

Most lenders prefer that your DTI be under 36%. While it is still possible to qualify for a loan with a DTI of up to 50%, it gets more difficult the higher your DTI is.

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