You found the house of your dreams. (Bonus: It came in mint condition!) Survived the mental stress of applying for a mortgage and the physical exertion of move-in day. Now, you’re sitting in your kitchen, sipping a cup of coffee, and listening to your kids play in the next room over. The four walls and roof overhead have truly become your home sweet home.
You know you’re living the American Dream. Yet, in the time since purchasing your home, you’ve started to wonder: Should you refinance your mortgage? (After all, isn’t mortgage refinancing supposed to lower your monthly costs and save you money?)
To get the answer, you need to understand the basics of home refinancing.
What Is a Mortgage Refinance (or Re-Fi)?
Refinancing itself is a pretty easy concept to understand. When you refinance your mortgage, you replace your existing home loan with a new loan that offers better terms.
You use the new refinance loan to pay off your current mortgage loan.
When you bought your house, you had the ability to customize several aspects of your mortgage, including the amount and type of interest (a fixed-rate loan versus adjustable-rate mortgage, or ARM), the length of your repayment period (10 to 30 years, typically), and even when you pay your closing costs (upfront or rolled into your loan).
With refinancing, you have the ability to personalize your loan in the same way. Or, you can switch things up. In other words, the features of your refinance loan can differ from the elements of your original mortgage.
For instance, let’s say you originally signed up for a 5/1 ARM (meaning the interest rate remained fixed for the first five years and adjusted once a year after that) and paid your closing costs at the closing. With a refinance, you could opt for a 30-year fixed-rate mortgage and roll the closing costs into your monthly mortgage payments.
And just like your original loan, you can choose which lender you borrow the money from when you refinance. Your options include online lenders like Ally Bank, as well as many brick-and-mortar banks and credit unions. You could choose to refinance with your current mortgage lender, or you could opt to go with a new one.
If you choose to go with a new lender, check to see if they have rules in place that could impact when you’re able to refinance. For example, you may have to wait a for a certain period (like four or six months after you purchase your home) until you’re able to refinance. Also, be wary that pre-payment penalties do exist, although they are uncommon. Ask your current mortgage lender to make sure you’re in the clear prior to deciding to refinance.
You can also increase or reduce the size of your down payment.
Keep in mind: If you have less than 20 percent equity in your home, your lender will likely require you to get private mortgage insurance (PMI).
When Is the Right Time to Refinance?
If you’re wondering if you should refinance your house, you probably know that you don’t just do it for the heck of it. Instead, you should have an idea of what you hope to achieve by refinancing.
Your possible goals could include:
- Obtaining a lower interest rate
- Converting from an adjustable-rate mortgage to a fixed-rate one
- Reducing the amount of your monthly mortgage payments
- Paying off your home faster
- Tapping into your home’s equity to finance something else
- Consolidating debt
One of the most common reasons why people refinance is because they’re looking to land a lower interest rate. Refinancing could help you accomplish this if:
- The Federal Reserve has lowered the benchmark interest rate from what it was when you signed up for your original mortgage.
- You have improved your credit score and could qualify for a better rate. Or,
- You’re switching from an ARM to a fixed-rate mortgage.
This is important because the higher your interest rate, the more you’re likely to pay for your home in the long run and the longer it will take for you to build equity in your home.
If you’re looking to refinance because you want to lower your monthly mortgage payments, reducing your interest rate will help in most cases. Or, you could refinance into a longer loan term, which typically helps to lower your monthly mortgage payments.
For instance, if you originally had a 20-year fixed-rate mortgage, you could refinance into a 30-year fixed-rate loan. Since you have increased the length of your repayment window, your monthly payment should be lower. Be aware, though, a longer loan term means you’ll pay more in interest over time.
Similarly, you could use a refinance to reduce the length of your loan term. This move not only means you’ll probably pay your house off faster, but you’ll pay less in interest charges, too.
Since you’re considering a refinance, that probably means you really like your existing abode. But that doesn’t mean you’re not looking to upgrade some of its features.
If your home has increased in value since you purchased it, refinancing can allow you to use some of its equity for other home-related expenses, like tackling a major home repair, upgrading your appliances, or building on a master suite.
The cash you pull out of your house could also be used to purchase a vacation home or pay down medical or credit card debt.
What if you already renovated your home, but used a home equity loan or home equity line of credit to fund the work? With a refinance, you can usually combine all your home loans and lines of credit into a single mortgage.
Types of Refinance Mortgages
Just like houses themselves, refinance loans are not one-size-fits-all. You have the ability to customize them for your specific financial situation and goals.
You can choose from three main types of refinance loans:
When you opt for a rate-and-term refinance, your new loan will be very similar to your old mortgage. The only factors that change are the interest rate, the length of the loan, or both.
For example, you refinance your 30-year fixed-rate mortgage at 5.5 percent into a new 30-year fixed rate mortgage at 4 percent.
This is the most popular type of refinance, especially when mortgage rates are dropping.
If you’re interested in pulling equity out of your house, this is probably the type of refinance loan for you. A cash-out refinance might reduce your interest rate or land you a shorter loan term. But its main feature is that it increases the amount you borrow, usually by 5 percent of your original mortgage or more.
You’re probably asking, if you’re borrowing more money than what you currently owe, what happens to that excess cash? When you have a cash-out refinance, you walk out of the closing with the additional cash in hand.
This type of loan is more risky for lenders, so with a cash-out refinance, you’re typically required to maintain at least 20 percent equity in your home.
As you might’ve guessed, a cash-in refinance is the opposite of a cash-out refinance.
With this type of refinancing, you will add to the equity you’ve already accrued in your house by putting more money towards the principal at the closing. Another way of thinking of it is you’re making a larger down payment on your refinance loan.
If you’re looking to reduce your interest rate, a cash-in loan could help you gain access to rates you wouldn’t have initially qualified for.
The Refinancing Process
Regardless of the type of refinance you’re interested in, and despite the fact that you already have a mortgage, you will need to apply for a refinance loan — and be approved by your lender.
That’s because you’re signing up for a brand-new loan with completely new terms.
Applying for a refinance is almost exactly like applying for a mortgage. But since you’ve been through the process before, you’ll probably be more comfortable throughout.
How to Get Started
First off, you’ll need to do your research and search for the refinance loan type of your choosing and a lender that offers you the best refinance rates. Then you’ll need to fill out the refinance application.
Along with it, a lender will likely require you to submit the following paperwork:
- Proof of income (W-2s and paystubs)
- Bank and investment account statements
- Proof of citizenship or residency status
Your lender will also conduct a credit check to determine your creditworthiness. The credit inquiry could ding your score by a couple of points, but it shouldn’t inflict any lasting damage. And you’ll need to have an appraisal conducted on your house to determine its current market value.
Not all mortgage refinancing requires credit and income verification. So-called streamlined refinance programs, which include Federal Housing Administration (FHA) and Veterans Administration (VA) loans, have fewer requirements, but they’re not available to every borrower. Also, there are cash-out limitations with some of these programs. Specifically, VA’s Interest Rate Reduction Refinance Loan does not allow cash back from loan proceeds.
Once you’re approved for your refinancing, you’ll schedule a closing. At closing, be prepared to pay closing expenses, which could cost 2 to 3 percent of your loan amount.
Closing costs can include the following:
- Application fee
- Loan origination fees
- Appraisal charge
- Title search and insurance
You can pay these charges in one lump sum at the closing, but if you want to avoid shelling out a large amount all at once, you can roll them into the loan. Just remember if you do this, you’ll pay interest on the amount.
So, Should You Refinance Your Mortgage?
Back to your original question. Now that you’ve learned the ins and outs of refinancing, you probably have a better idea of the answer.
Entering your current mortgage detail into a refinance calculator can help you determine if a new loan makes sense.
You should also think about how long you plan to stay in your house. If you plan to call it home for a long time, then refinancing might be worth it. But if you plan to put out a “For Sale” sign come spring, the amount you’ll pay for closing costs probably won’t make for any savings you pocket between now and then.
A refinance won’t make you love your home any more, but it can make paying for it a little more affordable.