With mortgage rates at their lowest since most of us can remember, many people are re-evaluating their mortgages and wondering if the time is right to refinance. According to a September NerdWallet conducted by the Harris Poll, 17% of U.S. homeowners with a mortgage on their primary residence refinanced in 2020 and nearly one-third (31%) of homeowners with a mortgage on their primary residence said they were considering refinancing within the next 12 months.
Considerations when deciding to refinance
As tempting as current rates may be, it is important to remember there are other factors worth considering when deciding whether or not to refinance. Things like the length of time you plan on staying in your current home, your short-term and long-term financial goals, and your credit score should all be considered, in addition to current refinance interest rates.
There are multiple triggers that typically get people thinking about refinancing. Mortgage rates that have fallen below the rate on a current loan are certainly a primary trigger. Other good reasons to refinance include:
- If you're looking to pay off the loan quicker with a shorter term
- You've gained enough equity in your home that you would no longer be required to pay mortgage insurance
- You're looking to tap some of your home equity for other sizable purchases
The longstanding rule of thumb is to consider refinancing if mortgage rates are lower than your rate by 1% or more. But this rule doesn't always hold true. In some situations, even half of a percentage point difference in interest rates can make the process worthwhile, depending on your situation.
In order to fully assess if refinancing makes financial sense for you, you need to start by adding up the costs of refinancing. Unless your lender is running a special promotion, refinancing is not free. Costs to consider include those incurred for an appraisal, credit check, origination fees, and closing costs. You'll also need to verify if your current mortgage includes a penalty for paying off the loan early.
The next step is to determine what interest rate you'll qualify for on a new loan. This is largely dependent on your credit score. Once you have your new rate, you can calculate your new monthly payments and see how much, if anything, you can save.
Once you have your new monthly payment schedule and have totaled your closing costs, you can calculate how long it will take you to recoup these costs. This is often called the "break-even point" of a mortgage refinance. Calculating how long it will take you to break even becomes critical if you plan on moving in the next few years. So if, for example, you confirm it will take 30 months to recover your costs but there is a chance you might move in two years for a new job, to accommodate a new baby, to downsize as an empty nester or for any other reason, you would actually lose money because of a refinance.
Another critical factor is the term of the new loan. If you've already been making payments for 10 years, do you want to start over again with a new 30-year mortgage? Even with a lower interest rate, you could wind up paying more in total interest expense over the extended term of the loan. Keep in mind that interest payments are front-loaded. That means the longer you've been paying your mortgage, the more of each payment that goes toward the principal instead of interest.
A better plan may be to replace a 30-year mortgage with a 15-year mortgage that has a lower interest rate. The shorter term allows you to pay off the mortgage in fewer payments, effectively reducing the amount of interest you'll pay over the life of the loan. Keep in mind, with this strategy your monthly payments will be larger, so you'll need sufficient income to cover the higher payments.
Different types of refinancing options
Most homeowners opt for a straight rate-and-term refinance that lowers their interest rate and provides an appropriate repayment term for the exact amount of the remaining unpaid mortgage. By stretching out the payment schedule, homeowners can effectively lower their monthly payments to increase their disposable income to cover other major expenses, such as college tuition, medical expenses or an auto loan.
Other homeowners go with what's known as a cash-out refinance through which they borrow more than they owe on the home and use to extra cash to wipe out expensive credit card debt, pay for major home renovations or some other major expense.
Qualifying for a refinance
Of course, even if after all these calculations, you determine that refinancing makes financial sense, you still need to qualify. Owning a home and having a history of making on-time payments does not guarantee approval. Your ability to refinance also depends on several other factors, including the amount of equity you have in your house, your income, and your creditworthiness.
Refinancing a home is like starting over again with the underwriting process. Your lender needs to determine if your home is worth more than the loan value, if you earn enough money to afford the monthly payments, and that you are not a bad credit risk. Before applying for refinancing, you should consider checking your credit report to ensure everything is current and there are no red flags. It could be that you have a stellar payment history but one of your accounts may have unknowingly been hacked or one of your creditors inadvertently marked you as being past-due in making payments.
There are many things to consider before deciding to refinance your mortgage. Unprecedented, low interest rates represent only one factor. Be sure to talk with your lender, explore your options and fully understand the long-term financial consequences of refinancing before you commit.
THE INFORMATION AND RECOMMENDATIONS CONTAINED HEREIN IS COMPILED FROM SOURCES DEEMED RELIABLE BUT IS NOT REPRESENTED TO BE ACCURATE OR COMPLETE. IN PROVIDING THIS INFORMATION, NEITHER CORTLAND BANK OR ITS AFFILIATES ARE ACTING AS YOUR AGENT OR IS OFFERING YOU ANY TAX, ACCOUNTING OR LEGAL ADVICE.