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Have you been thinking about refinancing your mortgage? You’re not alone.
17% of homeowners refinanced in 2019
62% of all home loans were refi’s in 2020
Most people choose to refinance within the first 3 years of their loan. In fact, the median loan age when people refinance was 3.1 years in 2019 and 2020.
We’ll explore each one of these below, so you can make a more educated decision whether or not refinancing is a good move for you. We’ll also explore the cons of a refinance, as well as a step-by-step walkthrough of how a refinance works.
Once you read this article, you’ll have a better idea of what is involved in a refinance and if it is right for you.
Reason to refinance: lower your mortgage payment
It pays to look into options to refinance your mortgage, and that is ultimately why most people refinance.
There are two scenarios in which you could successfully lower your mortgage payment:
You can lock in a better interest rate – If you got your mortgage at an interest rate of 5%, for example, you could save a significant amount by refinancing to a 2% or 3% interest rate.
The balance has significantly decreased – If you’ve been paying your mortgage for a few years, the loan balance will be lower. If you refinance, this balance will be what the monthly mortgage will be based on. Lower balance = lower payment.
Scenario 1: You can lock in a better interest rate
If you have only been paying on your mortgage for a few years, it’s likely that the loan balance hasn’t decreased enough to refinance and get a lower rate.
This is the case for most individuals, as from 1994 to 2020, the average mortgage refinance was the same or slightly higher than the original balance. But, you may still be able to lower your payment, simply by locking in a lower rate.
The recent pandemic has driven mortgage interest rates to an all-time low. In fact, in January 2021, the average interest rate for a 15-year mortgage was just 2.1%. That’s half of what it was in November of 2018!
For example, you got a 30-year $150,000 mortgage loan with a 5% APR. Your payment would be $805 (excluding escrow, taxes, and other fees). 2 years later, your mortgage balance is $148,000, but mortgage rates sharply decreased. If you could refinance your $148,000 mortgage with a new APR of 2.5%, your payment would be $585/month.
If you would include a $5,000 closing cost, that would make the payment $605 for $153,000. So in essence, you would reduce your monthly rate by roughly $200/month.
In the year 2020, the average mortgage refinance interest rate was 24% lower compared to the original loan according to Freddie Mac.
Scenario 2: The balance has significantly decreased
If your mortgage balance is significantly lower compared to the original loan amount, you could refinance to lower your payment.
For example, you have a 30-year mortgage loan of $150,000 with a 4% interest rate, your payment would be $716 a month (excluding taxes and any other escrow balances). Now, if you paid enough to only owe $120,000 on your loan, you could refinance. Let’s say the interest rate and escrow haven’t changed. Your new loan payment for $120,000 would be $573 per month.
If you were paying for PMI before it could be removed as well, reducing your new payment even more. That is as long as your home is worth 20% or more compared to the loan.
Reason to refinance: decrease the mortgage term
If you have landed a better paying job, or you inherited some money, it’s not a bad idea to rethink your mortgage. Most first-time homebuyers opt for a 30-year mortgage, as it would carry a lower monthly balance.
But, if you can now afford a higher payment, you could save thousands by decreasing that term with a refinance.
For example, if you buy a $150,000 home with a 30-year mortgage, locked in at a 4% APR, your payment would be $716. Now, if you were to refinance a year or two later, and opt for a 15-year mortgage, you’re looking at a new payment of around $1,100.
This is an increase of around $400/month. But, let’s see how much money you would save by doing so.
Original 30-year mortgage: You’re paying $716/month which makes a total of $257,760 in total mortgage payments after 30 years.
Refinanced 15-year mortgage: Let’s say you refinance for the same amount to keep things simple. You’re now paying $1,100/month. After 15 years, you’ll have paid a total of $198,000. This is a simple example of how refinancing to a higher payment, but a lower term could save you close to $60,000.
Not to mention, you’ll actually own your home in half the time.
If you’re looking to refinance to lower your term, be sure to shop around for the best possible interest rates. If you can shave off a percentage or two, your payment could be just slightly higher compared to what you’re paying now.
We recently refinanced our $100,000 mortgage from a 30-year to a 15-year. We also went from a 5% loan to a 2.5% loan. This resulted in an increase of just $50/month. Only, we’ll save over $100,000 in total cost, and we’ll have our home paid off 12 years sooner.
Reason to refinance: to get cash
You can refinance to receive a cash payment from the mortgage lender. People tend to do this to cover expensive home improvements. Is it worth it? Let’s find out.
Imagine you got a 30-year mortgage for a $150,000 home. You have been making payments for 2 years, and your current balance is $145,000. Unfortunately, you have some unforeseen costs coming up, let’s say your home needs a new roof and it will cost $10,000.
In this case, you could refinance for $145,000 + $5,000 in cash. Doing so will start a new 30-year mortgage (unless you opt for a shorter loan duration). Let’s add another $5,000 in closing costs, so your total refinance would be $155,000. This would raise your current rate from $716 to $740, given the APR is the same.
Not only does your mortgage balance increase by $24/month, but you also start a new 30-year loan, setting back your pay off date by 2 years (given you have been paying for 2 years).
So is refinancing for cash the best move to get cash? It could be if you can lock in a lower APR in the meanwhile. If not, there could be better options to get cash, mainly due to the closing costs and resetting the mortgage term.
Nonetheless, people cashed out about $26 billion by refinancing in 2019 alone. While that sounds like an enormous amount, it’s still far less compared to $105 billion in 2006.
What are the cons of refinancing?
Closing costs
The largest con of refinancing is having to pay closing costs once again. Closing costs typically range from 2% to 6% of the mortgage amount. So for a $150,000 mortgage, you could expect to pay $3,000 to $9,000 in closing costs. Depending on the lender, there could also be additional fees.
Hard credit inquiry
While it doesn’t come as much of a surprise, a mortgage refinance will include a hard inquiry of your credit. So you can expect your credit to drop around 6 points. Keep in mind that this change to your credit score is not permanent. If you continue making on-time payments, this small ding to your credit score will typically recover within a few months.
Approval is not guaranteed
Like with any loan or financial application, approval is never guaranteed. With a refinance, the lender will want to pull your credit, to see your payment history, active accounts, and any other loans that may affect their decision.
Additionally, they will want to make sure you can actually afford the mortgage. So a change in income could result in a decline, even if you are currently making the payments.
Paperwork
Even with a mostly online lender, like Quicken Loans, Chase, and similar banks, you can expect to do some paperwork. This includes but is not limited to your last 2-year tax returns, bank statements, and signing paperwork. Be sure to collect these beforehand as having to wait on your accountant could set back the application by a few days, and in turn, change your loan specifications like your interest rate, as this is subject to change until you are approved.
How does a mortgage refinance work
Regardless of why you want to refinance, it’s good to know how a refinance works exactly. It’s actually quite simple.
I recently refinanced through Chase, so I can give you a pretty clear walk-through of what to expect:
Start application
You contact a current or new lender and start an application. This typically means, providing them with basic information about yourself, the home, and the current loan.
Speak with the agent
A mortgage agent will then reach out to you with any additional information they may need, as well as present you with an estimated mortgage rate. In many cases, they will also be able to tell you if you are likely to qualify, even without pulling your credit. So it’s important to explain your situation well. Make clear what your monthly income is, and what your goals are.
At the same time, ask questions! Ask about their APR rate, estimated costs for different terms, closing cost fees, and anything else you’re wondering about. The agent is there for this specific purpose. If they aren’t forthcoming, shady, or pushy, consider using a different lender. Chase was extremely helpful, patient, and friendly during this initial 40-minute phone call.
Get qualified
Once you’re ready to move forward, you can give permission to pull your credit. Based on your credit pull, and income verification, the lender agent will be able to determine whether or not you qualify for a refinance. Income verification is typically done by submitting the last 2 years of your tax returns.
Be sure to keep this in mind! If you had a drastic decrease in income last year, or 2 years ago, this may ultimately affect whether or not you will be approved. In some cases, it’s worth waiting until the new tax year before you apply for a refinance.
Move forward with the application
If you are qualified, you can begin to move forward with the application. This typically involves submitting bank statements, current mortgage statements, and more. Most lenders have transitioned this process to an online portal.
With chase, for example, you can upload refinance documents, view open and completed tasks, and even chat with your assigned agent.
Sign the paperwork
Depending on the lender, you may be able to do this online, at a title office, or they may send a person to your home with the paperwork (this is what Chase did).
Sit back and relax
Congratulations, since you were approved and signed all the paperwork, the hard work is done! It’s now up to the lender to finish up the details and to provide you with your first payment date.
Things to consider before refinancing
Is right now a good time as far as interest rates?
Interest rates play a huge factor in the overall cost of your mortgage, and how much interest you’ll be paying over the next 15, 20, or 30 years.
Here’s a quick example: In this example, we’ll compare 2 loans. Both are 30-year loans for $100,000. 5% interest rate: $537/month, for a total cost of $193,256 2.5% interest: $395/month, for a total cost of $142,244
That’s a difference of $51,000, just because of the interest rate.
While your interest rate will largely be determined by your credit score, payment history, and overall financial background, interest rates do fluctuate.
Take the example below. This image comes from Bankrate and shows the average interest rate for January 2020 through February 2021.
The example above shows the difference between refinancing in March of 2020 and February 2021 was 0.9% for a 30-year loan. To put it in a dollar perspective, a 3.88% loan for $100k would be $471, while a 2.9% loan would be $416. Not a major monthly difference, but this adds up to a difference of roughly $20,000 in total interest.
Now, if a refinance is something you’re ready to do, sitting back for months to see if the interest rate drops don’t really make sense. But it does help to know if you’re refinancing in a good time, or not.
Did your income change in the last 2 years?
When refinancing, the lender will want to see your income for the past 2 years. That can have a negative impact on your approval and interest rate. If your income dropped in the past 2 years, the lender could think you’re not able to comfortably make the payment.
If your income recently increased, it probably won’t make much of a difference since they will look at the average of the past 2 years.
Will there be a need for PMI?
Private Mortgage Insurance is an added insurance that would cover the 20% difference between your equity, and your loan. In other words, if you were to buy (or refinance) a $100,000 home, the bank will gladly give you a loan for $80,000. But if you don’t have $20,000 to put down, you’ll have to pay insurance for that amount.
So how do you avoid PMI on a refinance? There are two ways:
Prove the home is worth more than the loan. This could be due to the overall home market, or due to home improvements. If your home is worth $120,000, there will be no need for PMI for a $100,000 refinance.
Put money down. If your home is worth $100,000, and you’re refinancing for $85,000, it could be worth it to put $5,000 down. It will remove PMI, as well as reduce your overall monthly payment.
PMI is just an added cost. It does not pay your home loan off faster. It’s simply there to cushion the risk of the bank. If you were to foreclose, the PMI will pay the bank a lump sum of cash. So it’s ideal not to have PMI on your mortgage.
Did your credit score recently change?
It pays to double-check your credit score before you apply. Something like a missed payment could drive your score down by 60 points or more. Not only that, it could cause lenders to view you as a high-risk applicant.
Before you apply, make sure to check your credit score. There are plenty of free tools out there to do so, like Credit Karma. Just keep in mind that the score these tools report is likely to be different than the score the lender will see. This is mainly due to different scoring methods. For example, my credit score on Credit Karma was 770 when I applied, yet Chase told me it was 730.
Final words
Refinancing can be a daunting or even scary thought if you don’t know how it works. But with proper planning, and knowing your goals before you get started, refinancing can be a breeze. Be sure the ask questions and know all the details of your new mortgage before you sign.
What's your take on refinancing?
Let us know below!
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