The combination of historically low interest rates, a red hot housing market and COVID-19 weirdness has led to a surge of refinancing activity during the past 18 months. Refinance applications more than doubled in 2020 – increased by more than 150% in 2020, according to the Federal Financial Institution Examination Council.
If you have never done it, or it’s been a while, refinancing can help you lock in a lower interest rate, save hundreds on your monthly mortgage payment and, ultimately, shave tens of thousands of dollars off your debt over the lifespan of a loan. And there’s more good news: Fannie Mae and Freddie Mac recently dropped the Adverse Market Refinance Fee on refinanced loans, which could save you $500 more on for every $100,000 refinanced.
Though refinancing can appear complicated, spending some time to understand the process — and how it could apply to your home loan — is one of the best financial investments you can make. Here’s everything you need to think about when considering whether and when to refinance.
How refinancing works
The refinance process is similar to closing on a home, except the new home loan pays off the old one. You don’t have to refinance with the same lender you’re currently with, but you can. It’s best to shop multiple lenders to find the best terms and rates.
Similar to when you bought your home, the refinancing process also involves a lot of paperwork, credit and financial checks and closing costs. Although a refinance loan is slightly less complicated than a new home loan, it can still take between 30 to 45 days to complete.
This is the most labor-intensive stage of the process. You’ll need to gather your financials — bank statements, pay stubs and your last couple of years of tax returns. You’ll work with the lender closely at this stage to address your credit history, income and debts.
2. Lock your rate
Once you get the good news that your refinance is conditionally approved and the process is moving forward, you may be asked if you’d like to lock in the current interest rate. Doing so guarantees your rate won’t change before closing. However, since refinancing rates always fluctuate, it’s hard to predict if rates will be higher or lower at closing than the rate you locked in. If you’re happy with the new payment amount based on the current interest rate, locking your rate could offer you peace of mind throughout the process.
3. Underwriting starts
The underwriting state happens behind the scenes. There’s not much for you to do except respond promptly if the underwriter requests more information from you. The lender will verify your financials and property details, as well as conduct a refinance appraisal that will set the new value of your home. The appraisal is an important part of this process since your home’s value will determine how much you can cash out and whether you have to continue paying private mortgage insurance.
4. Close on your new mortgage
Once the underwriting is over, you’ll be ready to schedule to close on your refinance. You’ll receive a Closing Disclosure a few days before to carefully review. The disclosure breaks down all the details of the loans including final closing costs, interest rates, payment amounts and more. You’ll review all the information again at the close and sign all the refinance documents.
When does refinancing make sense?
A refinance can be a great way to “do over” your current home loan when conditions are better. Here are a few good reasons why you might decide to refinance:
To save money on interest
A lower interest rate is typically the main reason to refinance. Most real estate experts agree that if you can drop your home loan rate by 1% or more, it’s a good time to consider a refi. However, sometimes a smaller rate drop can make it worthwhile.
Pete Boomer, Executive Vice President of PNC Financial Services Group, suggests considering a refinance if you can save as little as 0.125% of interest on a jumbo loan or 0.25% or more percent on a conventional home loan — if you can cover all of your closing costs within one year.
Based on the 1% rate-change rule of thumb and using a mortgage payment calculator, here’s how refinancing a $250,000, 30-year mortgage with a 4.25% interest rate changes with a 3.25% rate:
- Existing monthly loan payment (not including taxes and insurance): $1,229 a month
- New monthly loan payment after refinancing (not including taxes and insurance): $1,088 a month
As you can see, a refinance could save you $141 a month. However, this is a simplified explanation. You’ll need to take closing costs into account to determine how long before you break even and enjoy the benefits.
To get rid of private mortgage insurance
PMI doesn’t provide you with any insurance — it benefits the lender in case you fall through on your home payments. If you paid less than 20% when you bought your home, you’re probably paying for some form of mortgage insurance. Freddie Mac estimates PMI to be anywhere between $30 and $70 a month for every $100,000 borrowed.
You could eliminate the cost of PMI if your home’s value has increased at least 20% since you purchased the home. Refinancing when you have more equity can get the PMI condition removed, saving you money each month.
Your credit score has improved
If your credit score has improved since you purchased the home, you may be able to secure an even lower rate. Interest rates are already low, but many of the teaser rates you see advertised are reserved for applicants with excellent credit. Refinancing when rates are lower — and your credit score is higher — is a good combination to save significantly on your home loan.
You’re less than halfway through your home loan term
It’s also important to look at how far you are into your current mortgage. The bulk of the interest payment is front-loaded into your home loan. If you’re more than halfway through your loan term, then you’re in the home stretch and mainly paying principal. In this case, a refinance could end up setting since most of your earlier payments will go towards interest.
To pay off your mortgage faster
In some cases, you may want to switch from a 30-year mortgage to a 10- or 15-year option to pay your home off faster. This might be important if you’re closer to retirement or have decided you’ve found your forever home.
Donn Kim, Assistant Professor of Finance and Real Estate for Pepperdine Graziadio Business School says, “These days, 15-year loans are very cheap and the shorter term can help homeowners pay off their loans more quickly. Because the rates are low, the monthly payment likely won’t increase by too much.”
Capitalizing on a shorter-term mortgage when interest rates are low may not change your monthly payment much — and it may even raise it — but could drastically reduce the length of the home loan and save you tens of thousands on interest overall.
To convert to a different loan type
A lot can change over 30 years. You may decide you won’t be remaining in the home as long as you expected or you may plan to move in a couple of years. Refinancing to switch from a fixed loan to an adjustable-rate mortgage (or vice versa) may make financial sense.
An ARM typically starts off with a lower interest rate than a fixed-rate mortgage and this rate is locked in for a certain period of time. For instance, a 5/1 ARM locks in your fixed interest rate for five years, after which your rate will fluctuate.
ARMs may be a good option if you’ve decided to only live in your home for five to seven years. However, caution is advised before refinancing from a fixed-rate loan to an ARM. Once the fixed-rate period is over, rates can adjust higher instead of lower depending on market conditions — which could significantly increase your monthly payment.
To tap into your home’s equity
The average median sales price for a home is $374,900 as of July 26, 2021, up from the value one year ago of $322,600. That’s a 16% increase in average home values in one year. Some sellers have opted to cash in on this growth by selling. However, the current housing shortage may make it difficult to find another home to buy or rent.
Refinancing can be another way to cash in on some of this newfound equity without having to move with a cash-out refinance loan. This type of loan replaces your current mortgage with a bigger loan (to match your home’s new value) and offers you the difference in cash.
However, if you’re looking to tap in on your home’s equity, a home equity line of credit could be a better option. You’ll be able to borrow against your home’s equity without actually cashing it out. You’ll avoid increasing your mortgage loan and only pay interest if you actually borrow against your HELOC.
Refinancing costs to consider
Saving $50 or more per month on monthly mortgage payments can be enticing, but there are other factors to consider. Refinancing comes with closing costs, which Freddie Mac claims average $5,000, although the figure could be higher based on the size of the loan.
You could roll the closing costs into the refinance or pay them upfront. It’s less expensive to pay for closing costs out of pocket if you have the savings, or you’ll end up paying interest over the life of the mortgage on the closing costs, as well.
Can you afford the thousands of dollars you’ll pay to lock in a lower interest rate? You’ll need to decide how long you plan on staying in the home and whether the expense is worth it.
How to calculate your break-even point on a refinance
Once you have an idea of how much refinancing will cost you and how much you’ll save, it’s time to crunch numbers to determine whether it’s worth it. If you plan on living in your home for decades, refinancing costs will likely be worth the interest savings. However, a refinance may not be worth the expense if you’re selling your home in the near future.
Here’s how to find the break-even point:
- Calculate the monthly savings cost after you refinance. Use a mortgage calculator or ask your lender to help you. As an example, let’s say you’ll save $100 a month.
- Estimate your closing costs. Your lender or mortgage broker can provide you with the exact amount. For this example, let’s say you’ll pay $3,000.
- Divide your closing costs by your monthly savings to calculate how many months before you recover the closing costs. Using the above figures, $3,000 divided by $100 equals 30 months.
If you plan to stay in your home for three years or longer (36 months), you’ll break even towards the end of your second year and enjoy the savings you earned from a refinance. However, if you plan on selling in two years, you won’t make back the money you paid in closing costs from the savings.
