Since 2008, the interest rates for loans have been at unprecedented levels. Never in the period after World War 2 have rates been so low. Currently, as this article is being written in 2020, there is even speculation that the Federal Reserve may make interest rates negative (That has never been done in the US before, though Europe experimented with that for a period. Just to put it in perspective, that would mean lenders would have to PAY YOU to borrow THEIR money and you would have to PAY THEM TO save your money with THEM. It just doesn’t sound right).
But despite all the wackiness in the credit markets, it is a great time to consider taking advantage of some of the lowest interest rates on record. This is especially true for those considering refinancing their home mortgage. Before we get into specifics, let’s start with the basics.
What is a home mortgage? A mortgage, at its core, is simply a loan that a bank (or other lenders) grants someone who wants to purchase a home. Usually it involves a down payment of 20% (i.e. 20% of the purchase price) though the amount can vary based on the lender, the lendee, and the terms of the loan. Mortgages can be structured in many ways. They can be any number of years long, though they are typically 15 or 30 years. In addition, the rate of interest on the loan can be fixed or not. So you can perhaps get a loan for 30 years at 3.5% or you can get an Adjustable Rate Mortgage (ARM) where the rate is fixed for a certain number of years (say 5, 7, or 10) and then it will adjust based on the index the loan is tied to.
If you have a 30 year fixed mortgage at 3.5% and interest rates rise, then clearly it would serve no benefit to try to and renegotiate the terms since you would end up paying more. But what if the interest rates drop, and in particular, what if they drop significantly?
Well then, it may very well be time to considering refinancing, i.e. renegotiating, your mortgage to obtain better rates, more favorable terms, or both.
What is a refinance? A mortgage refinance is a new loan that replaces your old mortgage. There are many reasons to consider a refinance including to take advantage of lower market interest rates, extend repayment terms to reduce monthly payments, and to cash out a portion of your equity in the home. Let’s look at each in more detail and see if any apply to your situation.
(1) Get better rates: pretty obvious, this simply means that if you are paying 5% interest on the loan but rates drop significantly so that you can now pay as little as 3%, that is a compelling reason to refinance. Rates have vacillated slightly over the last 5 years after dropping significantly after the 2008 economic crisis.
(2) Get better terms: With a mortgage refinance you may be able to negotiate better terms than your original mortgage. For instance, if you have a 15-year fixed at a particular interest rate you could refinance your mortgage to get a 30 year fixed loan, which would significantly decrease your monthly costs, even at the same interest rate, since you would be paying that loan over double the period (though it would ultimately significantly INCREASE the absolute amount that you pay in interest over the life of the loan, for the very same reason) .
(3) Cash out some of your equity in the home: with a mortgage refinance you have the option of getting PAID some of the equity you have in your home, assuming you have enough equity, typically greater than 20% of the value of the home. This may be useful for a home improvement project, to pay off other debts, to invest etc. So, for example, if you have a home that appraises at $500,000 and you have $200,000 in equity, you can get a new mortgage where the bank loans you 80% of the value of the home ($400,000) and pays you $100,000 of your equity. You must be very careful however, with a cash-out refinance. It will increase the size of your loan and thereby your payments will likely be higher than if you kept the money in equity. Also, if the cash-out refinance pushes you towards less than 20% equity in your home, you will likely have to obtain private mortgage insurance (PMI), which can cost anywhere from 0.55% -2.25% of your loan amount each year, which is a sizable amount.
Refinancing your Home – Caveat Emptor! (Buyer Beware!)
All that sounds great … so what’s the catch? Well, there will be fees you have to pay to complete the deal. Actually, a bunch of them. Typically, a refinance will cost approximately 2-6% of the total cost of the loan. Here is listing of some of the more prominent fees to be aware of:
Origination Fees: this is what the lender will charge you to process your loan and obtain your credit report. These fees can also include the administration fee, the application fee, the underwriting fee, the document preparation fee etc. Beware that you can often negotiate these fees so use that as leverage to do so.
Appraisal/Inspection Fees: the lender/bank will have to hire someone to appraise your home and judge its value. This is a very important part of the process as it can mean a big difference in terms of what your home is worth.
In addition, the lender may require termite/pest inspection and a general home inspection. These are all charges you will be responsible for.
Mortgage and Title Insurance Fees: any mortgage loan backed by a government agency such as the Federal Housing Administration (FHA) or the Department of Veteran Affairs (VA) requires payment of mortgage insurance. Even if you have a conventional mortgage but put down less than 20% of the purchase price you will be required to pay for private mortgage insurance (PMI) to protect the lender in case of default(as described in the previous section). Title insurance is needed to protect the lender from the rare but not unheard of scenario where you do NOT actually have valid ownership of the property (also if there are any liens against the property). These costs vary according to loan value, down payment, property location etc.
Survey of the property and Improvement: you may also be charged to complete a survey of the property unless one has already been completed recently.
Discount Points: Discount points are prepaid interest that you make at the time of closing the refinance deal, in order to decrease or “buy down” your interest rate during the life of the loan. This may be something to consider IF you plan of keeping the loan for long time. If you think you may refinance again in the future you’d want to avoid buying down. One mortgage point typically amounts to one percent of the total loan. So, if you have a $100,000 mortgage, one discount point will equal $1000 that you pay upfront.
Key Points to Think About Before taking the Plunge
Calculate the Break-Even Point
Since refinancing to take advantage of better rates, terms or both, does not come for free, it would be best to determine how long it would take to cover the fees in light of the savings from the refinanced loan. If you do not plan on staying in the home long enough to at least cover those costs, then a refinance probably does not make sense.
Bolster your Credit Score
This is absolutely critical. You should absolutely know your credit score and credit history. Many banks and other financial service providers (like Mint) will often provide you an updated score at regular intervals. Keeps a close eye on it. Get a copy of your credit report from at least one, if not all of the major credit bureaus. Review the credit report for any inconsistencies. Understand that your credit report and score are treated the same as a Financial Report Card. If you don’t have an A or at least B on your financial report card (i.e. a credit score in the highest categories, 720 or above), then do everything possible to get your score as high as possible. Without a high score a lender will be unwilling to give you the bestyou best rate and terms for your loan.
Know your debt-to-income ratio
Lenders will be much more willing to lend to you, and with favorable terms, IF, your debt-to-income ratio is low. For this reason, try to keep your monthly fixed debts (i.e. auto loan, mortgage, school loans, child support, credit card bills, etc) as low as possible. To calculate your debt-to-income ratio, add up all your monthly debts and divide them by your grossly monthly income. This number should be less than 43%, which is the highest ratio a borrower can have and still get a qualified mortgage. It is recommended, however, that it be less than 36%.
Your home is typically your most valuable asset (and your most expensive one). It is important to periodically assess your mortgage and determine whether a refinance can be of benefit. However, understand that the refinance process is associated with fees that may (or may not) make it financially sound to proceed. Keep your credit score high and your debts as low as possible and honestly ask yourself what your goals are and whether a refinance is worth it.
Take Home Points
· A mortgage refinance is a new home loan that replaces your old mortgage
· Refinancing can be done to obtain better interest rates on the loan, better terms or both
· In order to get the best rates and terms, you MUST have a high credit score and a favorable debt-to-income ratio, so that a lender will judge you to be at low risk for default
· Understand the variety of fees involved in refinancing a mortgage
· Think hard about how long you plan to be in the house – if you plan on staying for an extended period, the refinance may be worth it. If not, then calculate the break-even point to see for yourself.