Taking advantage of low-interest rates through a mortgage refinance can be a smart move, but refinancing is not a ‘one size fits all’ solution. There’s a lot to consider when deciding on the best way to refinance your mortgage.
When you refinance your mortgage, you pay off your existing loan with a new loan with a different interest rate or term length. Many factors go into a refinance, from your down payment and interest rate to your loan terms and monthly payment amount. The right option for you depends on your financial circumstances and goals.
For example, if you want to lower your monthly loan payment, you’ll need a different refinancing solution than if you’re going to get cash for home repairs. When considering refinancing, first figure out the financial goals you want to achieve, and then choose the refinancing option to help you reach them.
Let’s discuss three common types of refinancing (rate and term, cash-out, and cash-in), the financial goals each type can support, and some other factors for you to consider when making refinancing decisions.
Rate and term is the most common method of refinancing and is often referred to as a ‘traditional’ refinance.
Rate and term refinances do exactly what the name implies: it enables you to replace your current loan with a new one that has a lower interest rate, a different loan term (the length of time to pay off the loan), or both. If your goal is to lower your monthly payment now, or if you want to spend less over the life of your loan, a rate and term refinance might be a good choice for you.
When rates are low, refinancing is an excellent way to lower your monthly mortgage payment since the interest portion of your payment is reduced with the lower rate. To ensure a drop in your payment amount, a good rule of thumb is to lock in a rate that’s at least 1% lower than your current rate.
If you have an Adjustable Rate Mortgage (ARM), refinancing to a conventional fixed-rate loan can help you pay less each month, too. The interest rate with an ARM is, as the name suggests, adjustable, meaning it can fluctuate according to the market.
A fluctuating interest rate can impact your monthly payment in a good or a bad way. When the rate is lower, your monthly payment could be low. However, if there’s an adjustment to the rate in the other direction, your monthly payment could go up significantly. Refinancing to a fixed-rate loan when interest rates are low can provide some stability in your monthly payment since the rate will remain consistent for the life of the loan.
Changing to a longer loan term through a rate and term refinance is another way to decrease the amount due each month. When you lengthen the term, the payments are spread out over more years, resulting in a lower payment.
It’s important to remember that lengthening the amount of time to pay back your loan may lower your monthly payment, but it will cost more overall because you’ll pay interest for a longer period of time. But refinancing at a lower interest rate may help offset some of the increased overall cost.
If your goal is to save money over the life of your mortgage, then a rate and term refinance that shortens your loan’s term might be the way to go. With a shorter term, you’ll pay off your loan sooner, which means you’ll pay less interest in the long run.
When thinking about a shorter term refinance, consider the fact that a shorter term will, more than likely, increase your monthly payment. But shorter term mortgages tend to help you get a lower interest rate when you refinance, which could help keep the new monthly payment more within budget.
Occasionally circumstances arise that require ready cash for a specific purpose. If this is the case for you, a cash-out refinance could be a good solution because it enables you to pull out some of your home’s equity and get a check for the amount you need quickly at closing.
Borrowers tend to choose a cash-out refinance to help pay for large expenses that require ready cash, such as home repairs, a home renovation, or even college tuition. The decision to cash-out some of your home’s equity shouldn’t be taken lightly since you’re borrowing more money than your original home loan amount.
Because of this, financial experts warn against using a cash-out refinance to pay for luxuries like a vacation and advise borrowers to use this refinancing option for necessary expenses that could benefit you financially down the road. For example, a Hawaiian vacation may give you wonderful memories, but monetarily, there’s no return on investment. On the other hand, a new roof or an updated kitchen can significantly increase your home’s value.
Some borrowers choose a cash-out refinance to pay off other high-interest debt, such as credit cards or student loans. With some credit cards charging as much as 20% interest, it might make sense to pay off debt balances with a home loan that has a significantly lower rate.
But keep in mind there are circumstances in which a cash-out refinance may not be a good choice. For instance, if you have a personal loan with a five-year term, using a 30-year mortgage to pay off that debt will end up costing, rather than saving, money because you’ll pay interest for an additional 25 years.
The other refinancing option, a cash-in refinance, is the opposite of a cash-out. Instead of borrowing more money and increasing your loan, you pay a sum towards your mortgage principal to decrease your loan balance.
If your goal is to eliminate private mortgage insurance (PMI) and lower your monthly payment, then a cash-in refinance is something to consider.
Lenders require payment of PMI for protection against borrower default if your loan-to-value (LTV) ratio, which is the ratio between the market value of your home and the outstanding loan amount, is above 80%. If you pay down your loan balance with a cash-in refinance and, as a result, decrease your LTV ratio to below 80%, you’ll no longer be required to pay PMI each month, which means a lower monthly payment.
Since a cash-in refinance provides a way to pay down your loan balance, you end up borrowing less when you refinance. A smaller loan combined with a resulting lower LTV ratio could help you qualify for a great low interest rate.
Also, when you reduce your loan amount, you reduce how long it takes to repay it, which means you’ll pay less interest over the life of the loan. A cash-in refinance is a great way to save money over time, but you’ll need to bring a lump sum of money to the closing table. So it’s essential to weigh the benefits of getting a better rate and saving on the overall cost of your loan with the advantages of keeping that money liquid or investing it in other ways.
Your financial goals are not the only thing you need to think about when developing your refinancing plan. Your current financial circumstances, such as your credit score, your home’s equity, and how much you’ll pay in closing costs, help determine which refinancing option makes the most sense for you, too.
Your credit score and your LTV ratio are big factors in determining the rate you qualify for when you refinance. Lenders use this data to assess the level of risk associated with a borrower. A higher credit score (700 and above) and a lower LTV ratio (below 80%) means less risk for the lender, which translates to a lower interest rate for you. Before you begin the refinancing process, be sure to check your credit score and calculate your LTV ratio to see if you’ll qualify for a rate that’s low enough to make refinancing worthwhile.
The amount of equity in your home is important, too. Equity is your home’s current value minus the amount you still owe on your existing mortgage. For example, if your home is valued at $350,000 and you owe $150,000, then you’ve built $200,000 in equity. Lenders like to see that you’ve built up at least 20% equity, but the more equity you have, the better your chance of qualifying for a great low rate when you refinance.
As with most things in life, refinancing isn’t free. Expect to pay closing costs no matter which refinancing option you choose. The many fees associated with home loans, like origination fees, appraisal, title insurance, etc., can add up to cost 2% – 5% of the loan amount. So it’s crucial to weigh the benefits of refinancing against how much it will cost you.
If you finance the closing costs into your new home loan, the savings from your lower rate won’t truly materialize until after you reach the break-even point when your monthly savings are greater than the closing costs. In this case, you’ll need to decide if you’re willing to wait to reap the savings of a refinance.
There’s no single, perfect refinance solution that works for everyone. Finding the best way to refinance a mortgage comes down to your individual financial circumstances and goals. And with so many things to evaluate, choosing a refinancing option that makes the most sense for you can be challenging.
When armed with knowledge and advice from a trusted financial partner, it’s easier to make sound decisions that help you reach your goals. Our team of experts at Partners Financial FCU are here to answer your questions, address your concerns, and guide you through the process.
Check out the resources below for mortgage refinancing advice and other helpful tools: