Smart Investment Management
If you closed on your mortgage just a few months ago, doing it all over again is probably the last thing on your mind. And when you refinance, that’s what you’re doing: replacing your old loan with a new one. But it’s smart to get a handle on the basics of refinancing now, because if interest rates drop significantly in the future, you want to be ready to reap the benefits.
A lower monthly payment can be one of those benefits, but unless you’re struggling financially, it isn’t the main reason to “refi.” The point is to own your home free and clear sooner and to save money over the life of the loan. On a 30-year, $200,000 loan, lowering your interest rate by just 1 percent adds up to $40,000! As you can see, refinancing is an important part of managing the investment you call home.
Yet way too many homeowners do nothing when rates drop. So many that researchers are trying to figure out why. Further, nearly 60 percent of those who do refinance don’t save as much as they could, according to one study. Probably because there are so many factors to weigh and numbers to crunch.
But don’t worry, a refinance doesn’t have to be perfectly calculated to pay off. Educating yourself about refi pitfalls will help you avoid most of them.
Top Refinancing Mistakes
First, let’s take a quick look at the most common mistakes homeowners make.
1. Taking an interest rate that’s too close to your current rate. You might not save money in the long run and could even lose some.
2. Not locking in your interest rate. Rates change constantly, and a spike could ruin the savings that make a refinance worth doing.
3. Automatically rolling fees into the new loan. You’ll pay interest on the sum. This strategy can be legit if the math works and it makes the refi affordable for you.
4. Not refinancing at all. Like we said, there’s a lot of money at stake.
These tips alone will put you ahead. But there’s much more to know if you want to make the most of refinancing.
The Many Ways to Refinance
A lower interest rate is just one of the things to consider when you refinance, but it is key to saving money, so let’s start with that.
A lower interest rate
If you still haven’t taken a good look at an amortization calculator, it’s an eye-opening exercise: watch as a lower interest rate drops your monthly payment and saves tens of thousands of dollars over the life of the loan.
$200,000 @ 4.5% = $1,013 monthly payment, $164,813 in interest total
$200,000 @ 3.5% = $898 monthly payment, $123,312 in interest total
Pretty compelling!
No more MIP
Is your first mortgage an FHA-backed loan? Then you know that one of the trade-offs was a mortgage insurance premium (MIP), which is usually required for the life of the loan. The only way to get rid of that monthly burden is to refinance into a conventional mortgage, and it can definitely be worth doing. PennyMac has good info on the pros and cons of making the switch.
A shorter term
You’ll build equity faster, pay off your mortgage sooner, and save a ton on interest. Fifteen and 20-year terms are common; the shorter the term, the lower the rate.
30-year term @ 4.5% = $164,813 total interest (payment $1,013)
15-year term @ 4.5% = $75,398 total interest (payment $1,530)
Now a shorter term plus a lower rate:
30-year term @ 4.5% = $164,813 total interest (payment $1,013)
15-year term @ 3% = $48,609 total interest (payment $1,381)
You can see how a shorter term alone will save you a huge amount of interest, but at the cost of a much higher monthly payment. Combine a shorter term and a lower interest rate, and you save even more, with a more manageable payment.
Refi to prepay
The problem with a shorter term is higher monthly payments. You have less flexibility if money gets tight. Alternative: you take a lower rate, but not a shorter term. Then, instead of pocketing the monthly savings, you keep making the same mortgage payment, i.e. you make extra payments on principal (ask your loan servicer about the best way to do that).
You don’t get the extra-low rate of a shorter term, but you still pay much less interest and get ahead faster — without being bound to the bigger payment.
Take the earlier example: refinancing from 4.5 percent to 3.5 percent on a $200,000 loan. The lower interest rate drops your monthly payment from $1,013 to $898, a savings of $115 per month. If you put that $115 toward principal every month, you’ll pay off your mortgage more than five years early.
A fixed rate
If you went with an adjustable-rate mortgage when you bought your house, you’ll probably want to refinance and lock in a fixed rate a few months before your rate is set to go up.
Cash-out
A “cash-out” refi is a way to extract all or part of any equity you’ve built up. The new loan is enough to pay off your old mortgage, plus any closing costs, and leave you with some cash.
However, just as with a home equity loan (see “Home Equity”), we recommend exploring other options first. Do you really want to wipe out your equity? Is whatever you want that cash for worth the risk of using your home as collateral? Plus, cashing out could increase your loan-to-value ratio and force you to buy mortgage insurance, or pay more for it.
Cash-in
You can also add to your equity when you refinance. In other words, make a big payment on principal. It’s another way to lower your monthly payments (maybe enough to do a shorter term or refi to prepay) and save on interest.
Some lenders offer a cash-in alternative that lets you lower your monthly payment without the hassle or expense of refinancing. It’s called “recasting” or “re-amortizing” (FHA and VA loans aren’t eligible). You still put a chunk of money toward principal —minimums vary — but your interest rate and loan term stay the same. The fee for doing this is far less than for a refi, as little as $250. Lenders rarely advertise recasting, so you’ll have to ask about it.
Should You Refinance?
It comes down to one question: How much money will you save? Alas, calculating the real answer takes some work. Lower monthly payments make it feel like you’re saving money but don’t always equal lower costs overall. In fact, you could be spending more over the life of the loan!
By far the most common mistake homeowners make is refinancing at a rate that’s not enough below their current rate. Here are some questions that will help you find your bottom line. Remember, the decision depends more on your individual situation than on the market. If it’s not clear, a homeownership advisor can help.
How long will you live in your home?
This is important because you need time to recover the closing costs. They vary from state to state, even city to city, but you can usually expect to pay at least $2,000 (that figure can be quite a bit more in premium markets, for example San Francisco). The break-even period is usually at least two years.
A refinance calculator will help you determine the minimum payback period. Check out the ones at Bankrate and Ally. They take different approaches, so you might find it worthwhile to try both. But here’s some quick math, just for example:
Let’s say that five years ago, you closed on a 30-year mortgage for $150,000 at a fixed rate of 6.0%. Now you’ve prequalified for a 30-year fixed rate mortgage with a 5.0% interest rate. The closing costs for the refinance are estimated at $3,125. How long it will take you to get that back?
For simplicity’s sake, let’s do the math using the current monthly payment for principal and interest only (no taxes, no insurance): $900.
$900 – $805 = $95
Step 2: Closing costs ÷ Monthly savings = Months to break even
$3,125 ÷ $95 = 33 months
In this refi scenario, then, it would be almost three years before you got back the closing costs. If you expected to stay in your home longer than that, the refi might make sense.
Keep in mind, though, that this level of calculation gives you a minimum payback time. To refine your numbers, read on.
How do the amortization schedules compare?
If the minimum payback period you calculated above makes sense for your situation, then try doing a more complicated, more precise calculation of the true cost of refinancing: compare the remaining amortization schedule of your current mortgage and the amortization schedule of the new mortgage.
- If you’re going to pay the closing costs out of pocket, subtract that same dollar amount from the principal balance of your current mortgage. Why? Because you could put that money toward principal instead of toward refinancing.
- Next, subtract the total amount you’ll save on monthly payments from the principal of the new mortgage. Similar idea as above: without the refi, you would be paying that toward principal.
- The month in which this modified principal is less than the principal owed on the old mortgage is the true payback period.
Yeah, this is kind of complicated for some of us. It’s explained in more detail at Investopedia.
What’s the total payoff amount?
What’s left on the old mortgage the month before you close on the new one versus the total payoff amount of the new loan? The old amount will be higher by that month’s interest, but any higher and you’re increasing your total payoff amount — i.e. the total cost of your home.
What are the long-term costs?
If you’re 5 years into a 30-year mortgage, for example, you’ve paid a lot of interest but not much principal. If you refinance with a new 30-year mortgage, you’re starting over with almost as much principal as before, which can wipe out the benefit of the lower interest rate. The loan might even cost you more in the end.
If you can’t afford the monthly payments on a typical 15- or 20-year term, ask your lender for a custom term that matches the years left on your old loan. That way, you won’t lose the progress you’ve made.
Can You Refinance?
When rates drop, too many homeowners miss the refinance boat because it turns out they can’t qualify or can’t afford the fees. Plan ahead and that won’t be you. You’ll need enough equity in your home, a solid credit score, and cash on hand for closing costs. You’ll have more leeway on all of that if you have an FHA or VA loan and want to refinance into another.
Do you have at least 20% equity in your home?
Typically, that’s the minimum. Another way to put it: you need a loan-to-value ratio (LTV) of 80 percent or less. Your LTV is your current loan balance divided by your home’s current appraised value. For example:
Was your down payment on the low side, or have home values been falling in your area? You could miss the cut-off. However, mortgage insurance might take care of that. It will eat into the savings you’re getting by refinancing, but it could be worth it. If you’re already paying mortgage insurance at the time of the refi, this probably won’t concern you.
Unfortunately, the only sure way to know how much equity you have is to pay the hundreds of dollars required to order a professional home appraisal and go through the application process. So it’s smart to get a realistic idea of your home’s value before you do all that. Check out Zillow, Trulia, and others for your own home’s estimated value and recent sales of similar properties.
Is your credit score at least 660?
That’s usually the cutoff for a conventional loan, but some lenders go lower. Even if you can qualify with a lower FICO score, you might not want to: remember, the lower your score, the higher your interest rate, the more you pay in the long term. If your score is on the low side, refinancing could be a wash.
Want to bring up your FICO score? It can take some time, but it’s pretty straightforward. Here are the six best ways get started.
Can you afford the closing costs?
Just like the first time around, you’ll pay closing costs. In fact, refis often have higher escrow requirements. You could consider a “no-cost” refi, but that usually sticks you with a higher interest rate for the life of the loan — which will cost you a lot more than paying the fees up front.
But wait: Do you have an FHA or VA loan?
Are you short of where you need to be on your equity, credit score, or closing costs? Federal Housing Administration and Veterans Administration “streamline refinance” programs have less stringent requirements and often lower closing costs, because they’re simpler: you’re basically swapping a new interest rate into your existing FHA or VA loan. As always, individual lenders have their own rules, so it’s worth shopping around.
As part of their simplicity, these programs don’t usually require an appraisal, as long as you won’t be folding your closing costs into the loan. Keep in mind that an appraisal could be in your best interest if you think the house is worth more than the lender does. Learn about the pros and cons of refinance appraisals at Bankrate.
MyMortgageInsider.com has details on FHA streamline refinancing and VA streamline refinancing.
10 Tips for a Smart, Smooth Refi
Let’s say you’ve done the math and decided it’s time. Here’s how to make refinancing go your way.
1. Shop around
It’s easy to go to your current lender, which might even offer special rates to existing customers. But see what else is out there for rates, points, and fees. If you don’t have time for this legwork, consider a broker. The broker’s fee usually adds to your costs, directly or indirectly, but it might be worth it — especially if, without help, you would end up not refinancing.
2. Protect your credit score
The higher the score, the lower your interest rate. Lenders check it when you apply, and often again right before you close, so hold off on opening new accounts and new debt of any kind.
3. Correct credit errors fast
If simple errors on your credit report are hurting your FICO score, or you’ve paid off a major debt and your report doesn’t reflect it yet, ask your lender about “rapid rescore.” Corrections or updates will be made in a matter of days instead of weeks or months. Bankrate details how it works.
4. Lock in your rate
Too many borrowers wait and hope that rates will go down even more, only to watch them go up. It’s hard to catch it just right. The main thing is to end up better off than you started.
5. Hold off on renovations
Taking cash out for home improvements? It might be tempting to jump in now, but don’t! If the house is too ripped up, it won’t appraise well and your lender won’t close on the loan.
6. Be available to your lender
This isn’t the time to go on vacation or do a digital detox. Lenders have more paperwork to do these days, so an open line of communication is more important than ever.
7. Pay attention to escrows
There are various ways to close your old escrow account and fund the new one. It’s usually best for you to get the money back and pay into the new account yourself.
8. Watch out for fees
Make sure no stray fees get rolled into the loan, with the result that you’ll pay many years’ worth of interest on them.
9. Confirm no prepayment penalties
They’re nice for the bank, but not for you. You want the right to pay off your loan early, so triple-check this! Penalties are often indicated with a tiny checkbox that’s easy to miss.
10. Back out if it feels bad
When you refinance with a new lender or tap your home equity ever (whether by cash-out refi or home equity loan), federal law gives you three days after closing to cancel the deal. Learn more about this “right of rescission” and how to exercise it at the Consumer Financial Protection Bureau.
