Did you know you can change your loan financing even after you close on your home? Homeowners are not required to pay the same monthly payment forever. In fact, when they complete the refinancing process, they make significant changes to their monthly payments that typically work in their favor. Mortgage refinancing can help homeowners reduce the interest rate and monthly payment, providing more financial freedom to leverage money elsewhere.
What is Mortgage Refinancing?
Refinancing a home is essentially taking out a new loan to pay off your existing mortgage. While it may sound counterintuitive, taking out a new loan can help owners secure lower monthly interest rates and better overall terms, making it easier to make their monthly payments.
The refinancing process is similar to that of applying for an initial loan. It takes roughly the same amount of time to close. It has many of the exact costs associated with a typical mortgage loan. Here is a simplified version of the steps needed to refinance your mortgage:
- Contact your lender to initiate the preapproval process.
- Provide the lender with the necessary documents and other required information.
- Receive mortgage refinancing options that include the new monthly payment, interest, payment terms, and any discount points.
- Go through the closing process, similar to when you take out an initial mortgage, to start your new loan. This process includes similar expenses, such as the appraisal fee, as part of the costs due on closing day.
Mortgage Refinancing Costs: What to Expect
It is crucial to understand that, just as with closing on a mortgage, the refinancing process also involves closing costs. While these rates may vary, homeowners can expect to pay between 2% and 6% of the new loan amount in closing costs. These line items are commonly rolled into the loan amount, which slightly increases monthly payments but does not require homeowners to have the cash on hand.
When Should Homeowners Choose to Refinance Their Mortgage Loan?
There are several reasons why someone might want to refinance their home, with the most common being to secure a lower interest rate. Mortgage interest rates move with the market. Both the local and general economies influence changes in interest rates, so when they are low, many homebuyers jump at the opportunity and refinance to take advantage of the lower interest rates.
While there is never the “right time” to refinance, the general rule is to wait until one of these circumstances applies:
- Substantial savings – Calculate the break-even point where the costs of refinancing do not outweigh the savings over the term of the loan.
- Determine the time you plan to occupy your home – Even if you have a higher interest rate, if you only plan to live in that property for a few more years, it might not be worth refinancing at all if you owe more due to closing costs.
- Building a good credit score and history – Just like when applying for the initial mortgage, keeping a high credit score will help you secure better mortgage terms when refinancing.
- Building 20% equity on your property – To remove the Private Mortgage Insurance (PMI), some loans have to be refinanced (like FHA). However, the typical conventional loan might not require this. Nonetheless, homeowners should contact their lender when they have at least 20% equity to qualify for a refinance without requiring additional PMI.
- Cash-out options – Often used by homeowners looking to repair their home or use the money to leverage the purchase of an investment property, cash-out options utilize the equity of the existing house to finance other investments (or remodels). These payments are typically higher and have a higher interest rate than the usual mortgage, and are referred to as a Cash-out Refinance.
Mortgage Refinancing Pros and Cons
Like all investments, refinancing a home comes with its advantages and risks. Refinancing your home can help reduce your overall costs and the term of your loan. However, it can also require a larger loan, resulting in higher payments over time and possibly for a longer period.
Pros
Probably the most common reason someone would refinance their home is to secure a lower interest rate. This phenomenon was observed in 2020-2021, when historically low interest rates enticed many homeowners to refinance their homes, often securing loans with interest rates as low as 2.65%.
Still, although securing a lower interest rate is the most popular reason to refinance, there are other benefits to going through this process. Homeowners choose to refinance to eliminate their PMI because they have secured at least 20% equity in their existing loan. They may also opt for different loan features if their circumstances have changed, such as reducing the loan term from 30 years to 15 years.
Homeowners may also want to remove or add a co-borrower or cosigner. This happens after a marriage (or a divorce), and the borrower wants to add someone with better credit to secure more favorable loan terms.
Lastly, homeowners may be seeking funds through the cash-out refinance option. These funds will help them finance costly improvements to their property (like a new roof or a kitchen remodel), or leverage the down payment needed to buy an investment property.
Cons
Just like there are pros to refinancing, there are also cons. Typically, these are categorized into three main areas: closing costs, negative impacts on credit scores, and the requirement to pay off or incur additional debt in the long term.
- Closing costs – Refinancing still requires many of the same line items as when initially purchasing a home. Think of costs like an appraisal, loan origination fees, attorney fees, and the like. While some of these fees can be negotiated and reduced, they can significantly impact your monthly payment (if you roll the closing costs into your loan) or the amount due at signing.
- Negative impact on credit score – Credit scores take a long time to increase, and many homeowners work to keep them at desired levels (700-800). When seeking preapproval to refinance, your credit score will need to be confirmed, which results in a hard inquiry on your credit history. Many homeowners experience a decline of approximately 10 points in their score after processing their preapproval, which typically lasts a few months. Hard inquiries remain in your credit history for about two years. Additionally, since refinancing pays off the initial mortgage, it will be reported as closed on your credit report, which may also impact your credit score, lowering it further.
- Longer loan term and possibly more debt – Homeowners need to set clear expectations regarding their closing costs and monthly payments before reaching closing day. Overall, you may pay more than the initial loan amount over the life of the loan. These additional costs may create difficulty in making payments or make it harder to borrow more in the future.
Is Mortgage Refinancing Right for You?
When evaluating the benefits of mortgage refinancing, determine if it is the right move for you. Good credit, lower interest rates, and better terms are all favorable traits of refinancing your home. You should avoid refinancing your home if your savings will not be substantial, you’re already having trouble making payments, or you wish to avoid accumulating additional debt.
If you’re considering refinancing your mortgage, now might be the time. Homeowners should take advantage of lower interest rates, weigh the pros and cons of taking out a new loan, and decide if the result works for them.
