This resource is part of the Innovative Funding Services (IFS) educational collection on refinancing.
Learn When Home Loan Refinancing May Be Right for You
Mortgage refinancing is the process of replacing your current home loan with a new one. It can be a difficult and expensive undertaking, but it may benefit you.
When refinancing your mortgage, you need to ensure that your new loan meets your needs without too many drawbacks or financial risks. We will explore some common reasons people have for refinancing their mortgages including reducing the cost of a home, switching to a fixed rate mortgage, borrowing against the equity in a home, or removing a cosigner from a mortgage. Then, we will look at some of considerations to keep in mind when refinancing like closing costs, how long you intend to stay in your home, and the amount of time and effort you can afford to put towards refinancing.
Situations When Mortgage Refinance May Make Sense
Borrowers refinance their home loans for financial and non-financial reasons. Let’s look at some situations in which refinancing may make sense for you.
When Your Credit Has Improved
Perhaps the most common reason for refinancing a mortgage is to save on the cost of a home in the long run.
Generally, for a mortgage refinance to save you money, you will need an approval for a home loan that costs less than the finance charge remaining on your current mortgage.
More specifically, achieving this goal requires you to determine the total cost of every mortgage refinance offer you receive. In some cases, your total cost will simply equal your finance charge (i.e. the total cost of your loan from interest charges and closing costs). However, you may face closing costs that are not part of your finance charge (e.g. possibly the appraisal fee), so you will need to add these to your finance charge to get the total cost of a mortgage offer. If your goal is to save in the long run, go with the least expensive of your offers, as long as it is less than the finance charge remaining on your current mortgage. You can learn more about determining the cost of a mortgage refinance here.
To secure a mortgage that is more favorable to you than your current one, most mortgage lenders need to see you as a lower risk. So, a good time to refinance is when your credit profile has improved since getting your original mortgage.
Your Credit Score
When your credit score increases, you are more likely to be approved for a loan that is favorable for you. If your credit score has improved, it may be a good time to consider refinancing.
However, contrary to what commercials and popular media may make you believe, your credit score is not the only factor that most lenders look at when evaluating mortgage applications. Rather, lenders consider your whole credit profile.
Your Overall Credit Profile
Your credit profile is multifaceted, so mortgage lenders look at multiple factors when consider you for a loan. The factors are sometimes know of the Four C’s of Credit:
- Credit Score – a measure of payment history with higher scores indicating lower credit risk. Your credit score(s) are based on your payment history as recorded by the three major credit bureaus, Equifax®, TransUnion®, and Experian®. While different credit scoring systems exist, most lenders look at your FICO® Score, based on the scoring system by the Fair Isaac Corporation (FICO). However, many mortgage lenders will not simply rely on your credit score when evaluating your payment history. In many case, lenders will review the details of your payment history especially on your current mortgage loan along with your credit score.
- Collateral – asset(s) that a lender can take possession of if a borrower defaults on a loan. The collateral of a loan describes how much of the loan is backed up by real world value. In the case of mortgages, collateral is often the home itself. When you apply to refinance your home loan, lenders will generally look at the loan-to-value ratio, or LTV, of your current mortgage, which is the ratio of your home’s market value to how much you owe on it. If you owe more on your home than it is worth, it may be more difficult to refinance your home without a down payment because your collateral would not cover your lender’s losses in the event of a default.
- Capacity – a borrower’s ability to pay back his or her debt obligations. Lenders need to know that you are able to pay back your debts when they lend you money. So, they compare your income to your outstanding debt to see how much cash you will have every month to put towards your mortgage payments.
- Character – the qualitative factors a lender looks at to determine if a borrower is likely to pay back his or her debts. Character is the “common sense” factor lenders look at when evaluating your credit history. In some cases, a mortgage lender may overlook a missed payment or a difficult time in your life if your unique story tells its representatives that you are a better credit risk than your credit report would lead someone to believe. However, character alone is rarely enough to get an applicant a loan approval.
Learn more about the Four C’s of Credit in the context of vehicle loans here.
Changes in Interest Rates
The prevailing interest rates also influence the type of mortgage refinance you are likely to receive.
To put it briefly, when the economy is growing, the U.S. Federal Reserve, or the Fed, will raise interest rates to reward investment, to control inflation, and to keep lending from getting out-of-hand.
Conversely, when the economy struggles, the Fed will lower interest rates to encourage borrowing and to promote economic activity generally.
So, when rates rise, it is more difficult to lower your interest rate and APR with refinancing. And when rates fall, it is less difficult to refinance to a lower interest rate and APR.
However, small changes to the benchmark interest rate may not be enough to justify refinancing in most cases. Mortgage refinance is expensive, sometimes with closing costs rising to 2% or more of the principal, or the total amount borrowed. To justify those costs, your credit profile must put you in a position to benefit from a refinance in the interest rate environment in which you apply.
For instance, imagine you apply to refinance a mortgage after interest rates fall 0.25% and you are approved for a mortgage with an interest rate that is 0.25% lower than your current. But your offer comes with closing costs equaling 2% of your principal. Chances are, this mortgage refinance would be more expensive in the long run.
When You Want a Fixed Rate Mortgage
Many homeowners have Adjustable Rate Mortgages, or ARMs. These mortgages usually begin with fixed interest rates for a period of time, usually 5 to 7 years, and then adjust periodically after that, usually yearly.
ARMs are often attractive to homebuyers because they usually begin with lower interest rates and payments than fixed rate mortgages. However, when interest rates rise, an ARM can take a financial toll on a household as monthly payment increase.
Refinancing from an ARM to a fixed rate mortgage may be a good option for you if your mortgage interest rate is rising, and you believe you can refinance to a less expensive home loan. However, keep in mind that the closing costs of mortgages can be expensive. If you are considering refinancing to lock down your interest rate, ensure that you weigh the potential of interest rates rising further against the costs of refinancing.
When You Want to Borrow Against the Equity in Your Home
With most mortgages, as you make your payments, you will build equity (i.e. ownership), in your home. It is possible in some cases to pull cash out of the equity in your home by borrowing against your equity with a “Cash-Out Refinance.” For example, if you have a mortgage originally for $250,000 on your home and have built up equity of $100,000, you may be able to refinance your mortgage for $250,000, giving you $100,000 in cash. Unfortunately, cash-out refinancing is not a free and comes with many risks.
When you refinance to pull cash out of the equity in your home, you will have a loan balance that includes the value of the portion of your home that you once owned for a second time. Essentially, it will put you in the position of paying interest on a portion of your home’s value again.
Still, some borrowers maintain that cash out refinancing makes sense under certain conditions. For instance, a homeowner may find that cash-out refinancing is a way of borrowing cash at an interest rate (i.e. the interest rate on the new mortgage) that is lower than he or she could get with a personal loan and without losing the ability to write off interest and points (i.e. fees you pay to your mortgage lender to reduce your interest rate) on your taxes.
Similarly, some argue that pulling cash out of home equity can make sense when the cash is reinvested in the home through remodeling or restoration, potentially raising its value.
However, the merits of any potential cash-out refinance is highly dependent on the borrower’s financial situation. Consider carefully the pros and cons of cash out refinancing before undertaking it, and know that no rule of thumb can tell you if it will be worth it for you.
When You Need to Remove a Cosigner from Your Mortgage
When a relationship ends or someone moves out, your mortgage will not change. If you find yourself with a mortgage cosigned by someone you no longer need or want, a mortgage refinance may be a good option for you as it essentially replaces your current mortgage with a new one.
Refinancing to remove a cosigner does not mean, however, that you should ignore financial considerations when you apply for loans. If you are looking to refinance, you may as well search for the best deal you can get. Make sure you compare any refinance offers you get, looking for the one with the lowest interest rate, APR, finance charge, and total cost of closing.
While refinancing is a common way to remove a cosigner from a loan, sometimes it may be possible to remove a cosigner without refinancing. Some mortgage lenders may allow you to remove your cosigner from your mortgage if you can 1) prove that you can make the payments without the cosigner or 2) recruit a new cosigner with similar credit and financial resources to your current one. Still, in many cases, your only option for removing a cosigner may be to refinance.
Mortgage Refinance Considerations
Just because you find yourself in one of the situations laid out above does not mean refinancing is right for you. You should weigh the benefits and drawbacks of refinancing to decide if it is right for you. The following are some considerations to keep in mind before choosing to refinance.
Mortgage refinancing is expensive. A lower interest rate does not guarantee that a new mortgage will save you money because mortgage closing costs can significantly impact the cost of any mortgage, in the short run and over the life of the loan.
Always ask your lender for the total cost to close on your loan before accepting a mortgage offer. Learn more about closing costs and how they may affect your mortgage refinance here.
How Long You Intend to Stay in Your Home
In some cases, a mortgage refinance will save you money over the life of your loan, but cost you extra upfront in out-of-pocket closing costs.
If you do not intend to stay in your home for duration of your mortgage, you want to consider when you will “break even” on your upfront closing costs from your monthly payment savings (if refinancing lowers your payment). For instance, if a mortgage refinance reduces your monthly payment by $80 but comes with $1,760 in out-of-pocket closing costs, you would not recoup the upfront cost of the refinance for 22 months [22 = $1,760 / $80]. In this case, if you refinance and then sell your home less than 22 months later, you will lose money from refinancing.
Your Effort and Time
The process of refinancing your mortgage can take a lot of time and effort. Applying for and comparing mortgage refinance offers is time-consuming on its own. But to close on any mortgage generally requires a lot of work and patience. Generally, you will need to have your home appraised, provide various documents to your lender, and sit through a long closing meeting. So, consider how much time and effort you are willing to invest in refinancing your home loan before getting started.
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