Should You Refinance Your Mortgage? 6 Questions to Ask First
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In June of 2019, mortgage rates across the U.S. fell to a three-year low, dropping to a 3.73 percent average. Considering that mortgage rates in 2018 averaged out at 4.55 percent, this has caused real estate professionals, mortgage brokers, and the general public to sit up and take notice. Naturally, many homeowners are wondering if now may be a good time to refinance.
What Is Refinancing? A Quick Refresher
So what is refinancing, exactly? Simply put, refinancing a mortgage means paying off an existing loan to replace it with a new one. Refinancing your mortgage can be a tempting prospect for a variety of reasons, including lowering your monthly payments, taking advantage of a lower interest rate, or folding other debts into one larger loan.
However, it’s important to understand a few basic points before you jump in and start the refinancing process. You’ll want to ensure that the pros outweigh the cons, and that it’s the right decision—and the right time—to refinance. Let’s take a look at some of the most important questions to consider.
1. When should you refinance a mortgage?
Refinancing makes the most sense when it will lower the overall cost of your mortgage. Some of the most common scenarios for this are:
When mortgage rates have gone down.
When rates are at a market low, refinancing can potentially save you thousands of dollars. If you take the time to shop around and find the right refinance mortgage lender for your needs, not only are you more likely to get your best possible interest rate, but you may be able to decrease your monthly payments, too.
Refinancing when mortgage rates are low can also enable you to switch from an adjustable-rate mortgage (ARM), which fluxuates periodically according to the market, to a fixed-rate mortgage. The main benefit of a fixed-rate mortgage is that you no longer have to deal with fluctuating monthly payments, because your principal and interest payments will be fixed at one unchanging rate. That means that even if market interest rates increase, your payments will stay the same.
When you want to shorten the length of your loan
Switching to a shorter-term loan may mean higher monthly payments, but it can lead to big savings over time.
“If you have a 30-year mortgage with an interest rate that’s higher than today’s rates, you may consider refinancing to a shorter term, perhaps a 15-year loan,” says Alli Romano, a freelance writer specializing in finance, in an article for Lending Tree. By reducing the term of your loan, you’ll take advantage of lower rates and pay off your loan faster, resulting in overall savings.”
When the value of your home has increased
If the value of your home has risen, your equity has too. With a cash-out refinance, you can tap into your home’s increased value and use the cash for a variety of purposes, including paying off other debt, starting a business, or remodeling/repairing your home (which can ultimately raise the value of your property even higher).
Another reason to refinance when your home value has increased is to remove private mortgage insurance (PMI) payments. If you were only able to put down less than 20 percent when you purchased your home, you were probably required to pay PMI. However, many loans allow you to stop paying PMI once your equity reaches a certain percentage of your home’s value.
2. When is refinancing a bad idea?
Here are some common reasons why refinancing might not be your best option:
You’re not sure how long you’ll be staying
The longer you plan to stay in your home, the more likely you are to reap the benefits of the lower monthly payments refinancing could provide. Conversely, the less time you stay, the less likely you are to benefit.
It all has to do with the break-even point. “This is the amount of time it will take for you to recover the closing costs on the new loan,” explains personal finance writer Rebecca Lake, in an article for SmartAsset. “If you’re planning on moving before the break-even period ends, refinancing probably doesn’t make much sense since you won’t be reaping any significant financial benefits in the long run.”
The long-term costs don’t offset the short-term benefits
The prospect of a reduced interest rate is very compelling, but not if it hurts you in the long run. Say you have a 30-year mortgage and you refinance for another 30-year mortgage with a lower interest rate. Yes, you’ve lowered your monthly payments, but you’re essentially starting all over again.
In many cases, it’s just not worth it—especially when you factor in the associated closing costs and interest you’ll accrue over the length of the loan.
The closing costs are too high
Unsurprisingly, refinancing isn’t free. You’re essentially taking out a new loan, after all. And even if you have the option to roll your closing costs into your new loan rather than paying them up front, they don't just disappear. You pay for the convenience in the form of interest on the closing costs and the underlying mortgage as well.
There’s a hefty prepayment penalty
Some lenders will charge you a prepayment penalty if you violate the terms of the agreement you made with your lender about what you’re allowed to pay off and when. If you refinance your loan while the prepay period is still in effect, you could wind up owing your lender up to 80 percent of six months of interest on your original loan.
You want to tap into your equity—but probably shouldn’t
This is the downside of a cash-out refinance. While this type of refinancing is a great deal for some homeowners, it can be disastrous for others.
For example, let’s say you’ve maxed out your credit cards and you’re drowning in debt, but the value of your home has risen and you’ve got a good amount of equity. It’s understandable that you’d want to use a cash-out refinance to pay off your debt.
But be honest with yourself. What got you into debt in the first place? If you haven’t yet managed to avoid the temptation of whipping out your plastic, you may ultimately find that you’re worse off than you were before you refinanced—with hefty credit card debt and less equity in your home.
3. What credit score is needed to refinance a mortgage?
If you’ve boosted your credit score since you purchased your home, it may help you qualify for better mortgage rates. “Raising a credit score only 20 points can lower a monthly mortgage and save thousands on interest paid over the life of a home loan,” according to mortgage advice and news website MortgageLoan.com.
There are several other important factors that come into play when refinancing based on credit score, namely your lender, your debt-to-income ratio, and the type of loan you have. Here’s a basic breakdown of minimum credit score requirements by common loan type:
- Conventional mortgage refinance: 620
- Conventional cash-out refinance: 640
- FHA standard refinance: 500
- FHA streamline refinance: 500
- FHA cash-out refinance: 500
- VA interest-rate reduction refinance loan (IRRRL) & VA cash-out refinance: no minimum required
4. How soon can you refinance a mortgage after purchasing a home?
Although there are no set rules about when you can refinance a mortgage, it’s usually a good idea to have built up some equity in your home before you do so.
“If you have a high loan-to-value ratio and not much equity built up in your home, you may still get approved for a loan but the lender will charge you a higher interest rate,” according to The Nest’s Budgeting Money blog. “Some lenders want you to wait at least several months after buying your home before refinancing: this gives them the opportunity to see if you can make your mortgage payments on time.”
5. Is it worth refinancing for only a small interest rate reduction?
The conventional wisdom when it comes to refinancing is that the new interest rate should be at least 1 or 2 percent lower than that of your current mortgage loan.
However, due to the rising cost of housing, many real estate experts believe that this general rule of thumb no longer holds water. In many cases even a modest interest rate reduction can save you money. For example, if you have a $200,000 mortgage, a 1 percent reduction in your interest rate probably isn’t worth a refinance. However, if you have a $2 million mortgage, you could save a significant amount on interest.
The important takeaway here is that the advantage of an interest rate reduction largely depends on a number of factors, including your credit score, the fees you’ll pay if you refinance, and the current value of your home.
This is the perfect time to use a mortgage refinancing calculator to see if a minor drop in interest rates will save you enough to justify refinancing.
6. How long does refinancing take?
The average time period many mortgage lenders will cite is 30-45 days, but in reality it can take less time—or a lot more. The time period for a refinance hinges on a number of factors, including how efficient your loan officer is and how prepared you are. To help speed up the process, The Lenders Network recommends having the following documents prepared and ready for submission:
- Two years of W2s
- Two months of bank statements
- Previous two years of tax returns
- Profit/loss statement if you’re self-employed
- Proof of any other income
- Bankruptcy paperwork (if applicable)
You can also speed up the process on your end by responding as quickly as possible to every request. Since you’re already in your home, many loan officers don’t treat refinancing with the same urgency, so it’s up to you to be proactive and check in regularly. The old saying that the squeaky wheel gets the grease definitely applies here.
The Bottom Line: Is Refinancing Worth it?
Regardless of your reasons for refinancing your mortgage loan, make sure to do your research and shop around for the best deal— it may or may not be with your current lender.
Whether or not to refinance your home depends on a complex number of factors, and has everything to do with the current market and your particular situation. With mortgage rates historically low, you may be in a great position to refinance.
On the other hand, competitive mortgage rates won’t be enough to justify refinancing if you’re in debt and can’t afford the associated short-term and long-term costs. Take a good, hard look at all of the factors discussed above, shop around for the best deal (hint: it may not be with your current lender), crunch the numbers, and make sure to consult a reputable financial advisor who can offer you sound advice.
Refinancing your mortgage loan could be a step in the wrong direction if you don’t proceed wisely, but under the right circumstances, it could also be the best decision you make all year.