Refinancing Guide

What is actually refinancing?

 

By definition, refinancing is replacing your current loan, being it a mortgage or any other type, with a new one with the intention of obtaining more advantageous conditions: the pending debt, e.g. the remainder balance of the old mortgage will be paid off through the new loan, but under changed interest rates, deadlines or conditions intrinsic to the loan itself. You are not taking a second mortgage, but continuing to borrow with the desired adjustments to finance your home purchase; expenses outside the principal and interests, which are property taxes, home insurance and contingent PMI will be kept the same.

Many homeowners decide to refinance at some point of their mortgage lifetime: one of the main goal in mind for doing this is to lower the previous interest rates, in order to get decreased monthly payments and save on the long term. Rates on the market are on the lower side, and makes sense to consider locking mortgage with such cheap interests: a difference as low as 0.5% can make a noticeable difference for a budget. This is not only to advantage in itself, but becomes a necessity for some people: keeping up with the mortgage payments means sacrificing other things, like saving for a vacation, a big purchase or retirement.

As we are going to discuss, among other reasons there are: obtaining free cash for home improvement or a major expense like for tuition, shorten the mortgage duration, consolidating debt or an obliged choice to change the current lender. Sometimes things are done with too much hype and little information, and one may end up spending more money than before, complicated his/her mortgage, or still it may take too long to reap the wanted benefits.

Why refinancing a mortgage?

 
  • Reducing your interest rate: according to most of financial experts, you should seek for a 1-2% decrease of rate into your new mortgage. Some suggest that a 0.5% would be enough, but it will take longer to amortize the intrinsic costs of refinancing. The direct effect is an easing of your recurrent payments, which will lead to saving on the long run, provided the loan term is the same. When you succeed to get such reductions, you will be able to save thousands dollars over the mortgage lifetime, above all for larger and long-lasting loans. It will also build home equity more rapidly, because less money will be under interest and what is owed is actually cash home value the most. A good credit score is a qualifying condition for a better rate: it demonstrates you will be a careful payer, that means less risk for the lender. Be aware that interests declared by lenders are nominal: that will be a starting point, but your final rate will be determined based on the amount of money borrowed and credit score, still very close to the nominal.
  • Choosing a shorter loan term: this is done with the intent of paying off the mortgage earlier, to save on interests and it generally comes to mind when there is current availability (and commitment to pay) because of an improvement in financial conditions. In fact, the monthly payments will naturally rise. If, for instance, you wanted to switch a 30-year term with a 15-year refinanced mortgage, you should also compare the interest rates: assuming they dropped from 6% to 4.5%, it would be catching two birds with one stone, since the payments will be relatively low and last lesser.

Let’s say you have a current 30-year mortgage on a $175,000 home purchase value, with a fixed-rate of 6%; after six years, you find that interests are down to 4.5% and you consider to pay-off within 15 years: doing so, your monthly payments would increase of $137.66, but your lifetime savings on this new loan will be of $88,536.51, a huge sum that can be used for any other thing you want. Besides, an average closing cost on this mortgage would be of $4,798.39: this amount can be covered in 2 years and 3 months exceeded, a quite reasonable time. This is a sample scenario where refinancing would be a very good move. On the other hand, if you are in the position of paying off earlier, but refinancing resulted unconvenient (because of little savings, monthly payments not affordable or a too stretched period for amortizing initial costs) you still have the option to add extra-payments with different timings in your current mortgage. So, to recap: fewer payments mean less interests and saving in the long term, but higher monthly payments, and you have to find the right spot where they are just slightly over to compensate for the time term reduction.

  • Extending the loan term in order to reduce the monthly payments. This is less common among homeowners, but a viable option for borrowers who have unstable or low incomes, less than good credit scores or have faced an acute financial hardship: they have difficulty to pay in time, so they need to lighten the recurring burden by delaying the loan. Of course, it will cost more in the long run.
  • Switching type of mortgage: in many cases, one is in the situation of converting an ARM (Adjustable Rate Mortgage) to a conventional fixed-rate mortgage, or viceversa. This kind of choice is partly depending on how long you plan to stay in your home. Let’s assume that your first mortgage was a 5-1 ARM, and you found that after those five years the interest rates have rosen too much, you will be living steadly in your house for the remainder period, then you may want to do the switch toward a fixed rate, where you have a lower interest and predictability about future payments: this is a good reason to refinance. A wise decision could be also refinancing to a fixed rate when rates are at the lowest, so to freeze them. If instead, you were planning to sell or rent your property, and the trend of interests is a significant fall, then switching toward an ARM would be the apt choice, because you are leveraging on few years of low interests: your monthly payments will diminish accordingly. It is generally recommended that a rate is at least 2% lower for borrowers switching from fixed-rate to an ARM.

You could also be eligible to convert an FHA loan into a conventional mortgage, admitted that you wanted to get rid of the mortgage insurance payments.

  • Using home equity to access the cash necessary for an home-related big expense like remodeling, renovations, or others like financing tuition, a vacation, an emergency repair. This can be a good move if you have enough equity, that is to say the cash value in your home. For instance, if its current market value is $250,000 and you owe $150,000, you would have $100,000 of home equity: you are essentially adding this cash to the total amount of loan. You should also have a good credit score, which means you have not other pending payments still to be managed, so this type of refinance won’t represent a further debt. Interests rates will be applied to the surplus you are borrowing, and may be tax deductible in your situation. This is also known as “cash-out refinance”, and of course has its closing costs, that are the same of other refinancing options.
  • Debt consolidation: when you have other dues, such as credit cards repayments, or car loans, especially when they impose high interest rates, you can merge them into a unique lower-interest rate loan (your mortgage). That would give you more control and ease of mind: now you have a unique debt vs more debts to manage. However, you must be a kind of prudent individual: if you are being refinanced, your credit should be addressed only where it is intended to be, not to make “pleasure expenses”, so this has the potential to create a vicious circle of debt that may end in a default, and leading to foreclosure if you can’t ultimately make payments for the mortgage.
  • Postponing a “balloon” loan: refinancing can be also a mean to avoid shelling out a big lump sum due to a loan expiry, for instance an ARM, if you haven’t the current availability.
  • Eliminating PMI (Private Mortgage Insurance): in some cases, it will be possible to cancel PMI, which is required for a down payment lesser than 20% in a traditional fixed-rate mortgage, through refinancing into another mortgage or loan. Of course, this should result in a net gain. Likewise, one may want to get out of a FHA loan, to get rid of the expensive MIP.
 

In the very first years, the costs you have sustained for refinancing will exceed the savings: it is recommended you do a break-even point analysis in advance on your refinancing plan, that is to say calculating how much it will take to recoup the initial expenses; after that point, your will benefit the net gains of decreased payments. Consider if the period is long enough to justify the move.

Why not refinancing

 

If you are likely to put yourself in a risky situation, like making difficult to keep up with the amount of re-payments, or spending too much overall, it is best to not refinance at all. You don’t want to create more debt, where your goal was actually to reduce it. You have to put on a balance the risks and perks of your plan, that’s why doing the math is so important: at a first glance, one deal may sound advantageous, only to find that your benefits are minimal later. Remember that the major risk associated with any mortgage loan is foreclosure, in case you defaulted on your payments. So, consider the following points.

  • Operational costs: in financial jargon, they are the “closing costs”, vary by lenders and are subjects to State specific federal regulations. In general, they can account for a range of 2-6% of the principal balance, comprehending application and origination fees, home appraisal and legal fees.

They are thousands dollars you must be disposed to pay, and it will takes a number of years, depending on the amount of loan and its interest rates, to amortize the expense. Refinancing is not right ideal in the short term, unless you can afford to face these costs. Sometimes it is not even worth to spend that much, because the gains will be net for a too short remainder term, that’s the case when you are leaving your home or, less commonly, because of the mortgage expiring.

  • More costs for interests: this can happen when you spread the loan term with the intent to reduce the monthly payments: on the long run, you will end up paying more on interests.
  • Losing benefits of the previous loan: refinancing will automatically abort the features of the current mortgage, at least if you completely change the type of loan. For instance, converting a FHA loan into a traditional mortgage will eliminate all the forbearance practices you would have right to if you were late on your payments, or indeed facing hard times and ultimately risking a foreclosure. So, the advantage you may get through refinancing will be relative, and eventually surpassed by what you would renounce to.
  • Not having enough home equity: if you decided to make a cash-out refinancing, you should have enough cash value against which to borrow, otherwise you would actually assume a further debt toward your own home. Besides, it is advisable to use that cash only for strictly necessary expenses, that can add value to the property (if aimed at it).
 

When to refinance

 

In a nutshell, every time you can get a net tangible benefit on your finances, in the shortest time possible, without introducing new issues, then it is worth refinancing any mortgage or other loan. It lastly depends on your financial targets and conditions, as well as how much home equity you have It is common practice to refinance when rates drop, and again, there is general accordance about a reduction of at least 1% of interest rate compared to the old mortgage, admitting a 0.5% for smaller loans. You will also have to stay in your home for a time proportional to the new loan duration.

One of the first consideration is if the initial costs can be easily sustained, be recouped in a reasonable period of time and don’t overcome the wished savings. As mentioned, you should look at the “break-even point”: if you are comfortable with that timeframe where you are in a deficit, and the numbers are favourable for you, it is safe to say that you can proceed with applying to a refinance.

Lenders will determine your individual rate based on your financial status, to some degree: if your credit score has improved, this is the best way to qualify for a lower interest rate. That is the case when you have fixed any hard financial condition that created debt, aka a negative balance on due payments: now you may have settled up outstanding debts, otherwise your business has grown since the origination of loan (you are making more money). Try to gain momentum of historical low rates, and you will get the best conditions.

You need to renovate or make important repairments to your home, while not having other source of money available: a cash-out refinance is typically done by borrowing toward home equity. If you have enough of it, and possibly a credit score that is at least “good” (670-739), then most financial expert agree that this would be a good time for refi. Besides, home improvements will add value to the asset, so that eventually you will have an edge when deciding to sell or rent it in the future. It works like this: on your mortgage you owe $160,000, and you need $35,000 for a major renovation; refinancing will mean that your new loan will be of $195,000, and you are taking those $35,000 at closing as cash for the home expenses.

How do you proceed in order to refinance?

 

When you have made up your decision, you will proceed as with any other loan:

  • first, you compare among lenders to find the one that have better terms and conditions, obtaining pre-qualification and approval
  • then you will be ready to apply
  • you go through an appraisal process, necessary to get approved
  • if successful, you will begin making the repayments until payoff.
 

There will be some requirements: an original mortgage maintained for at least 12 months, home equity between 10-20%, proofs of steady income and optimal debt-to-income ratio, a clean credit history.

Be aware of conditions set by the lender, or review them if you are going to refinance from the same servicer. Search for all the additional costs: as mentioned, there will be the closing costs: origination fees and points (levies: one point=1% of the outstanding loan amount), application fees, home appraisal/inspection, title insurance and title search (insure for discrepancies in a property’s ownership), lender’s attorney fees (for paying potential disputes related to the loan). As a reminder, they can total a 2-6% of a loan’s principal, depending on its amount, home location and by lender. These costs can be enrolled in the total of the new loan, but they will subject to the interests. Some lenders, especially banks, offer refinancing with no closing costs: they will waive the requirement, but charge you with higher interest rates, so you will only get a short-term saving.

Some homebuyers may be eligible for a “streamline refinancing” which tend to have decreased overall costs through lower mortgage rates, focusing on less stringent credit and income requirement, less paperwork, no appraisal, an easier application and quicker approval process, as well as no closing costs. Of course, this will have its own costs and there is no guarantee that you will save on the long run, basically an easier way to access to a mortgage.

So, by all means refinancing must be an informed decision. Once you have the knowledge, get a pre-approval and compare rates: you can put the parameters into the calculator and see which option is more feasible for your availability and needs.