This July, mortgage rates fell to historic lows, and, naturally, many homeowners took note. But a lower interest rate is just one reason to refinance your home. Refinancing could also allow you to pay less in monthly payments, get cash to have on hand, or change mortgage companies. But despite its many potential benefits, refinancing can have significant financial repercussions—and when weighing the current economic climate, it's important to keep in mind that things can shift quickly. In a volatile market, interest rates can change while you’re waiting for your refinance to close.
If you’re wondering whether or not to refinance your home, consider these important factors.
What is refinancing and how does it work?
In the most basic terms, refinancing means exchanging your current loan and replacing it with a new one. The new loan pays off the old loan and should result in better interest rates and terms. But there are financial implications to refinancing too. For instance, you’ll have to pay your closing costs again, and your credit score could be temporarily affected after your lender runs a credit check.
To begin the refinance process, contact your current mortgage company and learn about your options. Depending on what your lender is willing to offer, it’s reasonable to shop around with other mortgage companies. (Switching lenders comes with additional fees and requirements, such as a new property appraisal, so bear that in mind if you do opt for a new mortgage company.) Just as you did when you bought your home, you’ll need to apply and be approved for the new loan.
When should you consider refinancing (and when shouldn’t you)?
You’ll probably hear the term break-even point once you start to look into refinancing. The break-even point is when the savings of the terms of your new loan start to equal out the costs of refinancing.
“The break-even point occurs when the total difference in the monthly mortgage payment and the refinancing costs is the same,” explains Baruch Silvermann, personal finance expert in Los Angeles and founder of The Smart Investor. “For example, if you need to pay $4,000 on costs, but refinancing reduces your monthly mortgage payment by $200, you will break even in 20 months, because $4,000 divided by $200 equals 20 months.” There’s no magic break-even number to aim for, but if you plan to move in the next two to five years, you likely won’t be benefiting financially enough from refinancing for it to make sense long-term.
And, yes, the current mortgage rate is an important factor too, explains Jenna Gray, Branch Manager/SVP of Mortgage Lending in Walnut Creek, California. “Locking in during a historical low will initiate savings of tens to potentially hundreds of thousands in mortgage interest over the life of the loan,” she says.
Below are a few other examples of when refinancing makes sense.
- You’re able to secure a lower interest rate. If your credit score has improved, you’re in less debt than you used to be, or mortgage rates have significantly dropped, you can anticipate approval for a lower rate.
- You plan on staying in your home for a while. Due to the additional costs, only consider refinancing if you are planning to stay put for the next five years or more.
- You want to change the terms of the loan to fixed rate from adjustable. With a fixed-rate mortgage, the interest rate won’t change, unlike an adjustable rate which can go up or down.
- You want to take out cash from the home’s equity. A larger loan with the new mortgage will enable you to withdraw the cash difference, typically used for home renovations or other property improvements.
- You want to cancel your private mortgage insurance. If you had less than 20 percent equity in your home when you first financed, you might have been required to pay private mortgage insurance. You may be able to cancel this when renegotiating the terms.
- You had a recent life change. A divorce or a death in the family may be reason to renegotiate or change the terms of your loan.
And here are examples of when you shouldn’t consider refinancing.
- You won’t be in your home long enough to benefit financially. If you don’t plan to stay in your home long enough to break even, the cost of refinancing may be too high to justify any benefits.
- Your credit score is low. The higher your score, the better rate you’ll be able to secure. If your score is low, try raising it before you refinance—even a few points may mean securing a better deal.
- You’re more than half-way through your mortgage. If you’re more than 15 years into a 30-year mortgage, for example, you’re already likely paying down the principal versus the interest. Refinancing may mean you’re now in a longer term loan where you’ll pay off more interest than you may be saving in monthly payments for the next few years.
What are the types of refinancing loans?
- A rate-and-term loan allows you to get a lower interest rate with a new mortgage, so you can lower your monthly payments or change your loan program from an adjustable rate to fixed.
- With a cash-out loan, the new mortgage will be larger than what’s currently owed, giving homeowners the option to exchange home equity for cash. In turn, a cash-out loan may result in a higher interest rate.
- In the case of a cash-in loan, homeowners will pay cash upfront at the time of refinancing to pay down an existing loan balance, or the amount owed to the bank. A cash-in loan can bring your mortgage under the conforming loan limit (the maximum loan amount set by the Federal Housing Finance Agency.) At the time of publication, the conforming loan limit was $510,400 in most areas, but $726,525 in San Francisco County, for example. You can see your local loan limit here. Loans above this limit are called jumbo loans and require special terms because they are a higher risk for lenders. Refinancing into a mortgage below the limit may result in a lower interest rate; thus, lowering your monthly payments.
What are the costs of refinancing?
Before you apply to refinance, be aware of all the costs that come with the endeavor, says Joseph Polakovic, owner and CEO of Castle West Financial in San Diego.
“Typically, the costs that you can't avoid are going to be the ones that are associated with changing title,” he says. “Other costs you pay could be origination fees—the cost charged by the lender for handling the loan application; typically .5 percent to 1 percent—discount points, processing fees, or an appraisal. All of these can be substantial, so it's important to understand and shop them. Escrow costs get brought up a lot, but oftentimes, that's not a real cost since you would be refunded the amount from your current escrow company.”
And don’t forget about the break-even point, which you should calculate at the start of this process. “Assess the costs of refinancing against monthly savings and future goals with your break-even point,” reminds Silvermann.
What should you do before you refinance?
If you’re familiar with your current mortgage terms, an online mortgage refinance calculator can help you determine your new monthly payment if you were to refinance and help you to calculate your break-even point. If you don’t know some of the information, call or set up a meeting with your current lender to discuss the costs of renegotiating the terms.
Be prepared to assess your current finances, especially if they have been impacted by Covid-19. “Refinancing right now has changed drastically for anyone who has had their employment affected,” Polakovic says. “You may need to wait a while until the lender deems your income reliable and stable. If your employment and wages have not been negatively affected, then the process will feel very similar.”
And, factor in the current economic climate, he adds. “Lenders initially had a large pullback in funding due to the significant unknowns caused by the pandemic,” he says. “However, as time has passed, most have resumed lending on the conventional side.”
Even if the pandemic is ongoing, homeowners may want to consider refinancing soon, Gray says. “As long as interest rates remain low, qualified borrowers [meaning those whose income or employment has not been negatively impacted due to Covid-19] will continue to explore saving in interest costs through refinance opportunities. I do not expect rates to increase sharply anytime soon, but we should expect servicers to adjust rates in order to slow down early payoffs and maintain well-performing mortgages.”
Could we see rates lower? Gray believes it’s possible but anticipates only marginally lower numbers.