Picture this. You’ve been living in your first home for a few years. Since you made the purchase (congrats, by the way), your credit score has improved, you received a promotion at work, and you’ve definitely learned a thing or two about how to be responsible with your finances.
You’re starting to consider refinancing your mortgage, but you’re still unsure if it’s the right move for you. Don’t worry, we have the answers.
What is a mortgage refinance (or re-fi)?
Simply put, a mortgage refinance loan means replacing your current mortgage with a new one (typically with better terms). Your new loan is then used to pay off the original, and you’re responsible for paying the new one.
When should I consider mortgage refinancing?
If, since you took out your original loan …
- You improved your credit score
- The U.S. Federal Reserve lowered interest rates
- You have an adjustable-rate mortgage (ARM) and your interest rate is adjusting (or has adjusted)
… you might want to consider refinancing to potentially land a lower interest rate or convert your ARM to a fixed-rate mortgage. A lower interest rate can result in not only smaller monthly payments, but could save you a hefty amount of cash in the long run, too.
You may also consider refinancing if you want to shorten or extend the life of your loan. When you shorten the length of your loan, you can pay off your home faster (potentially saving big on interest over time), while increasing the length of your loan can make monthly payments smaller and more manageable.
What types of mortgage refinancing loans are there?
Three of the most common refinance loans are rate-and-term, cash-out, and cash-in.
A rate-and-term refinance is just like the name implies: you adjust your interest rate, the length of your loan term, or both. For example, if you want to convert from a 5-year ARM to a 20-year fixed-rate mortgage, or shorten your fixed-rate loan from 20 years to 15, this is the type of refinance you should look into.
A cash-out refinance can also lower your interest rates or shorten loan terms, but your new home loan will be for a larger amount than your existing mortgage. For example, if you owe $100,000 and refinance with a cash-out loan of $120,000, you are giving up $20,000 worth of equity in your house, but getting to walk away from the deal with that amount in cash.
While borrowing more than needed may seem financially irresponsible, the extra money can have multiple smart uses (like a home renovation, paying off high-interest debt, or education.) But because a cash-out refinance poses a higher risk to lenders, you typically need to have at least 20% equity in your home.
On the flip-side of a cash-out loan is the cash-in refinance. This type of refinancing helps you lower your mortgage by increasing the equity on your home (and reducing the amount of your loan balance). You can think of a cash-in refinance as sort of like making another down payment on your home. Doing so can make your mortgage more manageable on a monthly basis or allow you to qualify for a lower interest rate.
Can mortgage refinancing help me pay for other expenses or pay off debt?
Refinancing your home can be a way to free up cash or consolidate debt. If your home has risen in value since you purchased or you have a low loan-to-value ratio (the amount of your loan divided by your home’s value), refinancing through a cash-out loan may allow you to use that built-up equity to pay for other home-related expenses, like a repair or renovation project.
Because mortgage rates are typically quite a bit lower than credit card interest rates (almost 10% on average), it could be wise to use low-interest debt from a cash-out refinance to pay off high-interest credit card debt.
What are the risks of refinancing?
There are transaction costs (typically closing costs are 2 to 3% of your loan balance), so make sure you’re planning to stay in your home long enough to recoup these costs and realize the potential savings from the lower interest rate.
Does mortgage refinancing hurt my credit?
Because refinancing requires applying for a new loan, lenders will review your credit history through a hard inquiry, which could have a slight negative impact on your score. But don’t let this keep you from exploring loan options. If multiple loan applications are received within a relatively short window of time (typically 2 weeks to 45 days), they’ll only be counted as one hard inquiry on your credit report.
The new-ness of a refinanced mortgage may also affect your credit score as the length of your credit history can be a big factor. (For instance, it’s 15% of your FICO credit score). Because older debts provide a better idea of how you manage debt, they are considered more valuable to lenders. So a new mortgage (that is paying for the same home) won’t have the exact same positive effect on your credit score.
When am I eligible to refinance?
There’s no timeline for when you can apply to refinance, but your credit, your income, and your home equity should all play a major factor when making your decision.
Specifically, if your credit score is less than stellar, you will probably want to wait until you’ve improved it (to help you snag a lower interest rate). Plus, lenders typically require borrowers to have at least 20% equity in their home (or a loan-to-value ratio —of 80% or lower) to qualify for a refinanced mortgage. If you have less than that, you probably will need to wait.
And like with any loan, you’ll need to prove to lenders that you have sufficient income to keep up with your monthly payments.
I want to refinance. How do I get started?
There are plenty of reasons to refinance, but it’s not something done on a whim. Before you dive into the process, consider what you hope to achieve by taking out a new loan.
Are you trying to lower your monthly payment or pay off your home faster? Do you want to convert from an adjustable-rate mortgage (ARM) to a fixed-rate loan? These possibilities can all be achieved by refinancing, and having a specific goal will help guide you when deciding which refinancing option to go with.
Once you’ve done research on refinance loan types, lenders, and rates, you’ll fill out an application. (Remember to submit all applications within a relatively short timespan to avoid potential hits to your credit score.) Along with your application, be prepared to provide proof of income (W-2s and paystubs), bank and investment account statements, and proof of citizenship or residency status.
Purchasing a home is a big step. But the decision-making doesn’t stop once you have your mortgage. After some time, it could be in your best financial interest to refinance your mortgage. Know your options and how to go about refinancing your original loan. Once you do, you could pay less overall or have a more manageable monthly payment — making your home that much more comfortable.
Want to learn more about your mortgage refinancing options?