While refinancing your home mortgage might sound like a good idea in theory, especially with interest rates falling, it may not always be possible for every homeowner, or even desirable, for that matter.
Before taking the leap, homeowners should ask themselves the following key questions to help determine if a refinance makes financial sense.
1. Do I have enough equity in my home?
The amount of equity you have in your home is the difference between what your home is worth and what you still owe on the mortgage.
Homeowners need to have at least 20 percent equity in their home to qualify for a new loan without paying private mortgage insurance (PMI). Adding PMI to the cost of a new loan could negate the benefit of a refinance.
“Determining whether you have equity is always a key question to ask,” says Matt Hackett, senior mortgage and finance expert for Equity Now, a direct mortgage lender. “Home values have been rising for years and many homeowners have more equity than they may think.”
A cash-in refinance is another option to consider for those who may not have enough home equity. This involves the consumer bringing money to closing and paying down their mortgage so that there’s a lower balance owed, Hackett says.
2. Do I have good enough credit?
Even though there are FHA loans for borrowers with credit scores as low as 500, it’s increasingly difficult for those with lower scores to find loans. The economic fallout from the pandemic is weighing on the credit market, and lenders are tightening their requirements, regardless of the guidelines set forth by government programs. The Mortgage Bankers Association’s recent survey indicates that May 2020 represented the lowest availability of loans since June 2014.
“Mortgage lenders in May responded accordingly to the risk and uncertainty in the economy,” said Joel Kan, MBA’s associate vice president of economic and industry forecasting, in a statement. “There was a reduction in supply across all loan types, driven by further pullback in investors’ appetites for loan programs with low credit scores and high LTVs.”
With lenders reluctant to provide financing, you might have a hard time getting approved for refinancing if your credit score doesn’t meet requirements
3. What are my financial goals?
Identifying exactly why you want to refinance is a crucial part of the process, says Mounia Rdaouni, assistant vice president of mortgage specialized operations for Navy Federal Credit Union.
“Homeowners will refinance for different reasons,” Rdaouni says. “Examples include taking equity out of the house to pay for home improvements; securing a lower rate, term or payment and consolidating debt into one payment.”
Many homeowners, of course, refinance to lower their monthly payments and boost cash flow. If this is your motivation, a mortgage refinance calculator can provide an estimate of what the new monthly payment will be after refinancing.
Other homeowners pursue refinancing to obtain a shorter-term loan (often with higher monthly payments) so that they can reduce overall interest costs and own their homes outright faster. Swapping a 30-year mortgage for a 15-year loan, for example, is a way to accomplish that goal.
“As a homeowner, you should discuss the reasons why you’re refinancing with your lender so they can help you find the product that would best meet your needs,” Rdaouni says.
You may also want to consider whether you hope to retire without a mortgage before signing on for a new 30-year loan.
“Some are not aware, but they could be refinancing into a brand new 30-year, which means they are starting over on their terms and not where they left off,” says Michele Hammond, a private home lending adviser with Chase.
Be aware that the current situation could complicate your efforts to use a refinance to meet your financial goals. Furlough, even though it isn’t a layoff, is viewed similarly to unemployment by lenders. When deciding to refinance your mortgage, consider how your current employment situation might impact your ability to get a loan.
4. How long do I plan to stay in this home?
A refinance generally costs about 2 percent to 3 percent of the loan amount. So before spending that money, think about how long you plan to stay in the home and then determine whether you’ll reach the break-even point before moving. Your break-even is the point when the savings you realize outweigh the costs incurred.
A rule of thumb is to calculate how many months it will take to recoup your closing costs. Let’s say your closing costs are $3,000 and your monthly savings are $125 per month after the refinance. It would take you 24 months to break even and start enjoying the cost savings of the lower interest rate on the new mortgage.
“The length of time a homeowner plans to keep the mortgage is a key input in the cost-benefit analysis,” Hackett says. “All else being equal, the shorter the time in the house, the less likely it makes sense to refinance.”
Additionally, if you’re close to paying off your mortgage, it might not make sense to spend the money on a refinance. That money might be better off going toward paying off the principal on your current mortgage.
“It might be tempting in a low-rate environment to want to take advantage of the lowest rate available. However, homeowners need to be aware of the closing costs and time it will take them to break even,” says Rdaouni of Navy Federal Credit Union.
5. What are the terms of my current mortgage?
Borrowers with adjustable-rate mortgages or interest-only loans might want to consider the potential benefit of switching to a fixed-rate loan as part of a refinance. With a fixed-rate loan, you have the peace of mind of knowing that your monthly principal and interest payment won’t change over the life of the mortgage.
However, some homeowners might want to put off refinancing an adjustable-rate mortgage. The Federal Reserve is keeping its benchmark near zero, and unlikely to raise it until 2022, so mortgage rates are likely to remain low and potentially fall further. Refinancing to a fixed-rate mortgage might not offer the savings you’d see in an environment of rising rates.
Pay attention to possible penalties, as well. While new loans today rarely have a prepayment penalty, some homeowners still have loans with that restriction, which could reduce the financial gain of a refinance.
Hackett suggests downloading a current mortgage statement to identify the various terms of your current loan.
6. Do I have a second mortgage or line of credit?
Lastly, those who have a second mortgage will face additional complexity when refinancing.
“This will change the calculus of the refinance benefit calculation,” Hackett says. “Do you want to pay off and close the second mortgage or do you want to leave it open and resubordinate it to the new first mortgage? Both scenarios are possible in a lot of situations, but it is important to discuss this with your loan officer.”
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