The interest rate banks are willing to lend for mortgages has been dropping for most of this year. This has led many people to refinance, or at least think about refinancing. Some people may be on the fence about refinancing. This article is about why people refinance and how to know whether refinancing is a financially savvy move or not. If you’re interested in how to buy a house, you should check out this article.
Reasons to refinance:
Refinancing to lower your monthly payments
If interest rates have dropped enough, and you expect to stay in your current home for a long time, you should consider refinancing. The rule of thumb most cited is you should typically start looking at refinancing when the interest rate has decreased by at least 1%. This is a handy guidepost but the truth is, the more time you have left on the mortgage and you expect to live in your house and the more you owe on your mortgage the better any difference in mortgage rates will be. E.g. even a .75% or .5% difference in mortgage rates could technically leave you better off.
Refinancing to shorten the length of the loan
If rates have dropped enough, you may be able to refinance to a shorter-term loan while keeping your monthly payments roughly the same. The reason this is advantageous is that shorter-term loans are inherently less risky from the lender’s perspective; thus they have lower interest rates attached to them. The lower interest rates and shorter time frame means you end up paying less in interest on your loan.
However, most people don’t use this strategy if they are trying to lower their monthly payments. The shorter-term of the loan will increase the monthly payment. E.g. going from a 30 year $150,000 mortgage at 3.5% to a 15 year $150,000 mortgage at 2% will actually increase your payment by roughly $300. But taken over the life of the loan, this scenario actually results in roughly $68,700 less in interest paid. Simply put, the shortened time frame and the lower rate allows more of your payment to go towards equity.
Refinancing to get rid of mortgage insurance
Refinancing to take advantage of a lower interest rate isn’t the only reason people should consider refinancing. Getting rid of mortgage insurance is also a fantastic reason to refinance. If you have a good payment history and/or the value of your home has increased during the time you’ve owned it, then you may be able to get rid of your mortgage insurance. Mortgage insurance can vary anywhere from .45% to 2% of the loan amount and is tacked on to your mortgage payment.
Many people end up with mortgage insurance because the loan is greater than 80% of the purchase price (i.e. you put less than 20% down). If you’ve paid down your mortgage or if the value of your home has increased, then it may no longer be the case that your outstanding loan amount is 80% of the appraised value of your home; it may have dropped substantially below that amount. Therefore, when you refinance your mortgage you may be able to get rid of that pesky insurance. This will lower your monthly payment and in conjunction with lower interest rates can save you substantial cash each month.
Refinancing to access the equity of your home
Lastly, people sometimes refinance their homes to take advantage of their equity position in the home. You may have heard of the term “cash-out refinance.” This term refers to a refinance that allows the homeowner to take out some of the equity in their home. The equity you have on your home is simply the market value of your home minus your mortgage balance.
Let’s say you originally put down $20,000 on a $100,000 home; this means you have an $80,000 mortgage and $20,000 of equity in your home. Let’s then say that you have $50,000 left on your original $80,000 mortgage and the value of your home has increased to $110,000. $110,000 minus $50,000 = $60,000 in equity in your home. The equity in your home has now tripled from $20,000 (the original cash you put down) to $60,000. If you wanted to access that equity in the way of cash, one way you could do so is by refinancing the mortgage to take some of that equity off of the table. You could for example refinance our example above to take $20,000 of equity out of the home. This leaves you with $40,000 of equity in a $110,000 home, which is still a pretty healthy amount of equity for loan purposes.
Most people use this strategy to access the cash they don’t have on hand. They then use this cash to pay off debt, pay for larger projects or education expenses, or to handle emergencies. Like all strategies listed above, you will want to make sure the value you gain access to isn’t wiped out by the cost. You shouldn’t do a cash-out refinance for $2,000 in cash if the loan is going to cost you $3,000. If you are paying off debt, you should also be sure that the interest rate on your mortgage is substantially lower than whatever debt you are trying to pay off.
How Should You Decide to Refinance?
The first thing you should be aware of when thinking about refinancing is the cost to refinance your mortgage. Refinancing is not a free process. There are fees involved and a typical refinance can cost 2%-6%. The first thing to figure out is whether the savings on your mortgage will be greater than the cost of refinancing. Many people will roll the cost of the new loan into the loan itself. To see if refinancing is worth it, divide the total cost of the loan by the amount of monthly savings you will get. This will tell you how many months of mortgage payments it would take before you actually saved any money.
Here’s an example: Say you have a $150,000 mortgage; your monthly mortgage payment is $900; you inquire about refinancing your current mortgage; you find out from your mortgage broker that the loan will cost $3,000 in total fees and that your new estimated monthly payment will be $800/mo.
First, ask yourself is how many months of payments will it take before this loan has paid for itself. The answer, in this case, is $3,000/$100 = 30 months; as long as you plan to at least stay in your home for the next 30 months, refinancing will leave you better off.
This is the payback period or breakeven point on a refinance; it tells you the point at which you are better off having refinanced. If you’d like to try a handy mortgage refinance calculator, you can find one here.
If the primary reason you are refinancing is to access the equity of your home to pay off debt, the process is essentially the same. However in this case you are calculating the value as the difference in interest payments on debt you owe vs. the interest on that debt at your mortgage rate.
As long as you are comfortable with the payback period calculated, and assuming your credit is in decent shape, you should consider refinancing. Here’s a link to a list of handy mortgage calculators for your own educational purposes.
If you would like to schedule a time to talk to learn more about the ins and outs of your mortgage, please do so with the form below!
Erik Goodge is a CERTIFIED FINANCIAL PLANNER™ and the President of uVest Advisory Group. He holds a B.S. in Economics and Cognitive Science from the University of Evansville. Erik is a Marine Corps veteran of the Afghanistan campaign and Purple Heart recipient. He is from Evansville, Indiana, and currently lives in near-by Newburgh with his wife and daughter.