When mortgage rates fall, many homeowners automatically think it’s an excellent time to refinance their homes. At the same time, its valid mortgage can help you lower your interest rates and monthly repayments. It will help if you make smart financial decisions regarding your overall financial well-being. This article explores why you should refinance and gives you step by step process of mortgage refinancing.
But, first, you need to understand what mortgage refinance is and how it works.
What is Mortgage Refinancing?
Refinancing is the process of getting a new home loan by changing the rates and terms of your current mortgage. Some people think that when you refinance, you end up with two loans. No. When you refinance, your old mortgage loan is paid off, and you are then responsible for the new loan.
Why Refinance Your Mortgage?
You should be clear on why you are choosing to refinance home loans. Some of the reasons homeowners opt to refinance mortgage include:
- To secure lower interest rates
This is the most significant reason why homeowners choose to refinance home loans on their existing mortgage. If refinancing can reduce your interest rate by at least 2%, then it is time you have an incentive to refinance your home.
When you reduce your interest rate, you save money which can be geared towards your retirement contribution. It also helps increase your home equity while decreasing your monthly repayments.
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- To shorten the term of the home loan
When the mortgage interest rates fall, you can choose to refinance your existing loan for another home loan without too much of an increase in the monthly repayments. Therefore, you enjoy a lower interest rate and almost the same monthly repayments for a higher loan.
- To convert their home loan from Adjustable-rate mortgage (ARM) to Fixed-rate mortgage (FRM)
Have you secured a home loan on an Adjustable-rate mortgage and want to switch to a fixed-rate mortgage. This is possible when mortgage rates fall. Although ARM offers lower interest rates than FRM, economic changes can lead to rate increases, where you end up paying more than when it’s FRM.
So when rates go down, take advantage and switch to a fixed-rate mortgage; this is especially good for people who plan on staying in their home for a long time.
With this switch, you do not need to worry about changes in your interest rates and monthly repayments because they remain the same for the life of the mortgage loan.
Switching from a fixed-rate mortgage to ARM with lower monthly repayments can be a sound financial decision when the rates are falling. This is best for homeowners who do not plan on staying in their homes for the long term. If the rates continue to plummet, the rates on ARM continue to fall, resulting in smaller monthly repayments.
However, this can be an unwise decision if the interest rise, as it will cost you more.
- To raise equity from their property
If you are in a financial bind and need emergency money, you can choose to refinance your home. However, this can lead to your destruction and loss of residence if you do not use the money constructively. You will find that some homeowners get equity from their homes to cover remodeling, and they justify it by saying that it adds value to their homes. Others may take out home loan refinance to cover medical bills or their children’s education.
You can also choose to refinance your mortgage to consolidate debt. Although this might be a good idea to replace high-interest rates debts with a low-interest mortgage, it may be the cause of your ruin.
After paying their debts, some people tend to go on a spending spree, which will only add more debts, making it a cycle. So, only refinance your home loan if you are sure you can resist the spending temptation
Refinancing is not feasible if you plan on moving from your home in the next few years or if your mortgage has a prepayment penalty.
Read Also: How to consolidate debt
Things you need to know before applying for mortgage refinancing
When applying for a mortgage refinance, you need to review these key considerations to ensure you make the right decision.
- What is the value of your home?
Knowing how much equity you have in your home is essential as it determines how much you will get. Conventional lenders are skeptical about advancing home loan refinance to homeowners with little or no equity.
However, you may be lucky to secure one with some government programs. If you want to refinance your mortgage, it would be best to have at least 20% equity.
- Your credit score
Due to people failing to keep up with their payments, mortgage lenders have tightened their rules, whereby they need you to have a credit score of 760 or more. You may find that you won’t access a home loan with the lowest interest rates, even with a good credit score.
And although you can access home loans with a low credit score, the rates will be higher, taking more time to pay. Therefore, make sure that your credit score is at 760 or over before applying for a mortgage refinance to enjoy low rates.
Learn how to fix bad credit fast if your credit score is too low.
- What’s your debt-to-income ratio
You may think that lenders will easily refinance a new one because you already have an existing mortgage. But this is not the case because apart from raising the bar for credit score, lenders are also currently strict with the Debt-to-income ratio.
Although having a high income, stable jobs, and substantial savings may qualify you for a loan, lenders want to make sure that your monthly mortgage repayment does not exceed 28% of your gross income. And that all your bills, including mortgage, account for 36% of your gross income.
- Cost of refinancing
Like mortgage pre-approval, refinancing has additional costs, such as closing costs and application costs. The total extra fees range between 3% and 6% of the total home loan amount. So before applying, check how much you will be needed to pay and how you can reduce the costs.
If you have enough equity, you can roll in the refinance costs into your new loan. Although some lenders offer a no-cost refinance, note that they will have a higher interest rate to cover these costs.
So, be sure to shop around for the most favorable rates, and remember to negotiate because nothing is fixed until you sign the contract.
Read Also: How to get a mortgage pre-approval
- Mortgage refinance rate vs loan duration
While many homeowners choose to refinance their home loans because of low-interest rates, it’s essential to establish your goal for refinancing. If you want the lowest rates possible for a long-term loan, then refinancing is a wise decision.
However, if you want to finish paying your loan as soon as possible, then you’d better look for a mortgage with the shortest term, and the monthly repayments should be an amount you can afford.
- Your break-even point
This is the point where your refinancing costs have been recouped through the savings gotten from refinancing your mortgage. For instance, let’s say refinancing costs amount to $3000, and each month you save $150 over your previous loan.
This means that it will take 20 months to recoup the whole amount. If you plan on selling your home after one or two years, refinancing will not be realistic. Refinancing is best for people who do not plan on moving from their homes soon.
- Private mortgage insurance
If you have less than 20% home equity, you will be required to pay Private Mortgage insurance when you refinance your home loan.
Fortunately, if you have PMI on your current loan because you do not need to pay again. However, if your home has decreased in value from the date of purchase, you will be required to pay PMI when you refinance.
If the savings from refinancing will not be enough to cover the additional cost of PMI, then it would not be a wise decision to refinance your mortgage.
- Taxes
Many homeowners love mortgage as it helps lower their federal income tax bill, and the higher the interest rate, the less the tax. However, when you refinance, you pay less interest, and in turn, your tax bill increases. But you should not avoid refinancing because of the rise in tax bills.
So, before refinancing your mortgage, consult with a tax expert to see what impact refinancing will have on your taxes.