Mortgage loan refinancing can help you tap into your home equity to free up some funds. But there are risks. Here is everything you need to know
Refinancing a mortgage means you pay off an existing home loan and replace it with another one. Why would a homeowner do this? There are actually numerous reasons, which include anything from obtaining a lower interest rate to tapping into home equity to free up some cash.
Because mortgage loan refinancing can cost as high as 6% of the loan’s principal—among other costs—it is critical to determine whether refinancing is the right choice.
Learn why are closing costs so high on a refinance in this article.
When does mortgage loan refinancing make sense? At what point can you refinance your home? And does refinancing hurt your credit?
In this article, we will answer these questions and more. Here is everything you need to know about mortgage loan refinancing.
Whether mortgage loan refinancing will make sense for you depends on several factors, including the reason you want to refinance.
Typically, refinancing is a good move if doing so will get you a new rate that is at least 1% lower than your current rate. Another consideration is whether your monthly savings will make a significant difference. How about the savings over the life of the loan?
To give you a clearer idea of whether mortgage loan refinancing will make sense for you, let’s look at the common reasons that homeowners refinance:
- Obtain lower interest rate
- Shorten the loan term
- Convert adjustable-rate mortgage (ARM) to fixed-rate mortgage
- Tap into home equity
Let’s take a closer look at each to determine if mortgage loan refinancing is the right move for you.
Obtain lower interest rate
One of the most popular reasons to opt for mortgage loan refinancing is to obtain a lower interest rate on your current home loan.
The general rule is refinancing is the right choice if you can reduce your interest rate by 2% at least. Keep in mind, however, that most mortgage lenders say savings of at least 1% is enough of an incentive to refinance.
To help budget some of the costs, you should use a mortgage calculator. Lowering your interest rate helps you to save money; it also helps you build up home equity more quickly. Plus, it can lower your monthly payments.
Shorten the loan term
When interest rates drop, you may have the chance to refinance your existing loan for another loan. While it may or may not significantly change your monthly payment, you can shorten the loan term.
For instance, if you have a 30-year fixed-rate mortgage on a $100,000 property, refinancing from 9% to 5.5% can cut the term to 15 years with a slight change in monthly payments to $817 from $805. Regardless of the exact figures, it is critical that you do the math to see whether refinancing to shorten the loan term makes sense for you.
Convert an adjustable-rate mortgage (ARM) to fixed-rate mortgage
Mortgage loan refinancing can enable you to convert an adjustable-rate mortgage (ARM) to a fixed-rate mortgage—or vice versa. Remember: ARMs can start out with lower rates than fixed-rate mortgages. However, periodic adjustments may result in rate increases that are more than the rate offered through a fixed-rate mortgage. If this happens, switching to a fixed-rate mortgage will get you a lower interest rate without worrying over interest rate hikes in the future.
The opposite is true as well. You may want to convert from a fixed-rate loan to an ARM, which usually offers lower monthly payments than a fixed-term mortgage. This can be an especially good financial strategy if interest rates are decreasing, and you do not plan to remain in your home for a long time. In this case, you can reduce the interest rate on the loan and monthly payment. However, you will not have to worry about how high rates will go in the distant future.
To tap into home equity
Homeowners usually access their home equity to pay for major expenses, which commonly include their child’s tuition or home renovations. Refinancing to remodel, for instance, is often seen as adding value to the property.
Another justification for refinancing is that the interest rate on the home loan is less than the interest rate on money borrowed from other sources. Yet another reason it makes sense for many homeowners is that the interest on home loans is tax deductible.
These justifications may very well be true. However, increasing the number of years that you owe on your mortgage loan is rarely a financially sound decision. It is also unwise to spend a dollar on interest to gain a 30-cent tax deduction.
Another time when mortgage loan refinancing might be a good idea is in the event of a serious financial emergency. If that happens, it is important to research your options for raising the money prior to refinancing. If, for example, you do a cash-out refinance, you might be charged a higher interest rate on the new mortgage compared to a rate-and-term refinance.
Most of the time, you can refinance a conventional loan as soon as you want. Before you can refinance with the same mortgage lender, you may have to wait six months. However, that does not stop you from refinancing with another mortgage lender.
One exception to this is if you do a cash-out refinance. This is when you borrow a larger sum than what is left on your home loan and get that amount in cash. If you want a cash-out refinance on a conventional mortgage, you have to own the property for at least 12 months. In this case, the exception is if you inherited the home or were awarded the property in a divorce or separation of domestic partnership.
Mortgage loan refinancing on your home means you are basically trading your current mortgage for another mortgage. Typically, your new mortgage will have a new principal and a different interest rate. Your mortgage lender will then use your newer mortgage to pay off your old one. This means that you will be left with just one home loan and one monthly payment.
There are various reasons why you might refinance your home. A cash-out refinance, for instance, will help you access the equity you have in your home. A rate-and-term refinance, on the other hand, will help you get a better interest rate and/or a lower monthly payment.
Mortgage loan refinancing may also enable you to remove another person from the mortgage. This is especially beneficial in the case of divorce or separation. It also allows you to add someone to the mortgage.
Mortgage loan refinancing may hurt your credit initially. However, it will likely help you in the long run. How? Refinancing can significantly lower your monthly payment and/or your debt amount. Both a low monthly payment and debt amount are things mortgage lenders prefer to see. While your credit score will usually drop a few points upon refinancing, it bounces back within a few months.
Mortgage loan refinancing: two ways refinancing can hurt credit
While your credit score will bounce back in a couple months, mortgage loan refinancing does have an impact. Let’s take a look at two ways refinancing can impact on your credit.
Multiple hard inquiries
A hard inquiry happens when a mortgage lender looks at your credit report. If multiple lenders make hard inquiries over several months, these inquiries will negatively affect your credit score. Note, as well, that hard inquiries stay on your credit report for two years.
To guard against the negative effects of hard inquiries on your credit score, you can first get organized. Line up the mortgage lenders you want to contact and submit your applications within a shorter time frame. Another good tip is to avoid having additional hard inquiries pulled for one year minimum after you refinance.
Old debt, new debt
Since they prove to mortgage lenders that you have a good track record, old loans are preferred to new loans. In other words, mortgage lenders want to see long-term accounts in good standing. Remember, payment history comprises 35% of your FICO score. Fifteen percent of your credit score is based on the length of your credit history.
When refinancing, your original home loan is closed and another one is opened. This also means your good track record is over and you start incurring new debt. It takes time, but you can rebuild good payment history on your new account.
If you want to go for mortgage loan refinancing, knowing when it makes sense for you and when it doesn’t is an important first step. Understanding if it is better to stay with your current lender or shop around, as well as how it may affect your credit, are also critical in securing you the best option for your current financial situation and your long-term financial goals.
Remember: the more knowledge you have, the better off you will be.
For help in getting the best deal when refinancing your mortgage, get in touch with one of the mortgage professionals we highlight in our Best of Mortgage section. Here you will find the top performing mortgage professionals across the USA.
Did you find these tips useful? Do you have experience mortgage loan refinancing? Let us know in the comment section below.