If you’ve watched television over the last 15 years or so, you’ve probably seen an ad to refinance your mortgage. They make it sound like the greatest thing ever, but it can’t be as good as they claim, right? Sadly, many Americans don’t understand the fundamentals of refinancing, making it challenging for them to determine if it represents a prudent financial move for them.
This post is intended to explain the fundamentals of refinancing, beginning with a basic overview of what the process entails before reviewing hypothetical scenarios in which it may or may not make sense. Let’s begin!
When you refinance a mortgage, you are simply taking out a new loan and using it to pay off your old one. The application process is comparable to what you went through to secure your initial mortgage, so you can expect to look for income verification, an assessment of your property’s current value, and any other documentation you may have needed last time.
Refinancing can be a great way to lower your interest rate, allowing you to pay less per month and/or build equity in your home more quickly. Experts used to say that refinancing was worthwhile if you could lower your interest rate by two percent, but many argue that one percent is all it takes to prove worthwhile in the current financial climate.
Refinancing can also adjust the term of your loan. For example, a 30-year fixed mortgage may have made sense when you were still getting established in your career, but maybe you are able and willing to pay off the debt in 15 years now. Refinancing to a 15-year term can help adjust your loan to your current needs. Note, however, that many lenders allow you to pay more on 30-year loans to save on interest and pay them off faster. It’s up to you whether you want to refinance to a shorter term.
Furthermore, refinancing can turn a variable rate mortgage into a fixed rate mortgage. Variable rates often start low, making them look attractive when you purchase your first home. However, the rate increases with the market, meaning that you could be paying far more than you bargained for by the 15th year of a 30-year term. A fixed rate provides cost certainty, and you may still end up with a better rate if your credit score has improved since you took out the initial loan.
It’s also possible to go the other way by converting a fixed rate loan into one with a variable rate. This probably isn’t a great idea since rates are currently increasing, but it can make your payments cheaper during extended periods of lower rates. It may also prove beneficial for individuals who don’t plan to stay in their home for much longer, as they will be gone by the time rates increase.
Finally, refinancing may allow you to fund a large purchase such as a car, remodel, or your child’s college education. You can also take advantage of the money to pay off high-interest credit card debt, but doing so often spirals into a cycle of continuous debt that ultimately becomes bankruptcy. Make sure you can trust yourself to stick to a budget before refinancing for this purpose.
If you plan to move out of your home in the relatively near future, refinancing may not be for you. Origination fees average between three and six percent of your loan, making it pretty expensive. There are also several application fees to consider. As a general rule of thumb, a worthwhile refinance will pay for itself in the form of lower interest rates or increased equity in a period of approximately two years. If you’re not planning to stick around that long, look for another financing solution.
Likewise, refinancing isn’t great if you have a lot of equity built up in your home. If you are five years into a 30-year term, you haven’t accumulated that much equity yet. However, it would be a shame to prolong your monthly payments if you are currently on year 29 of that same mortgage.
Finally, you will end up with a higher rate if you refinance with a lower credit score than you had when you were approved for your original mortgage.
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— Jacques Poujade (@PoujadeJacques) December 18, 2018
The information above provides a synopsis of refinancing, but the actual process can be much more complicated. If you need a helping hand to determine whether refinancing is right for you, contact my team at LendPlus, and we will help guide you through the entire process today!