There are many reasons why homeowners decide to refinance their mortgages. Often, those reasons are simultaneously financial and personal. As the years go by, our priorities and financial positions shift.
Are you thinking of refinancing your home? What’s your motivation? If you’re like millions of other people who read the financial press, you may simply want to take advantage of today’s low-interest rates.
Chances are, if you bought a house in the pre-COVID days, the mortgage interest rate you were given on your loan was higher than the rates mortgage lenders are offering today. Thirty-year fixed-rate loans reached an all-time low of 2.65% in January of 2021. And while rates are creeping up again, if you bought your house 15 years ago, you might score a loan at a rate two or more percentage points below what you committed to back the. All other things being equal, lowering your mortgage interest is a sure-fire way to make lower monthly mortgage payments. You can use the money you save each month to offset your fixed expenses—or to finance a dream. This is where a mortgage refinance comes into play.
Your reasons for wanting to refinance may influence the type of loan you pursue. Let’s take a look at your mortgage options and help you find the best mortgage refinancing deal for your needs: the one that aligns with you financial goals right now. And let’s talk about how to increase your chances of being approved for the loan you want.
Rate and Term Refinancing
If your aim is to spend less on your mortgage each month—which amounts to lowering the lifelong cost of your loan—then rate and term refinancing is probably a good choice for you. The concept is simple: you take out a loan for the amount remaining on you mortgage at a lower rate. That lowers your monthly payment. To take full advantage of your potential savings, you should take out your loan for a term that’s shorter than your original loan term—the number of years remaining on your original mortgage, for example. If you choose to take out another 30- year mortgage, your savings will decrease. You’ll pay a lower monthly payment, but because you’d be making more of them, the lifetime cost of your loan will be higher than it would be with a shorter-term loan. But if you don’t plan on staying in your home for very long, a longer-term loan may still suit your needs.
On the other hand, if you’ve amassed significant equity in your home, you may want to use that money to meet new financial goals. Maybe your kids are approaching college age and you need money to fund their educational expenses. Maybe your inefficient 20-year-old furnace is burning up gas—and cash—every month. Seniors age 62+ can also benefit from today’s low interest rate environment by refinancing their reverse mortgages.
Cash-out refinancing can help you meet those goals and more. Lenders rarely demand that you use the equity you take out of home for a specific reason. However, they do require you to maintain at least 20% equity in your home. In other words, you can refinance and take out up to 80% of your home’s appraised value.
Here are a few situations when a cash-out refi may make sense:
- You intend to use the money to renovate or make repairs to your home that will increase its value. Using your equity to improve your home may, in some circumstances, also give you a tax advantage. You don’t pay income tax on the cash you take out during a cash-out refi. And if you use the money to, say, install a fabulous new kitchen, you may be able to deduct the costs associated with renovation.
- You use the money to pay off high-interest debt. Chances are the rate you’ll be offered on your new mortgage will be lower than the rate you’re paying on your credit card balances.
- You’d like to use the equity in your home to purchase a second property that will generate income for you at the same time it increases in value. You can refinance your way into a single-family or multi-unit residence or a commercial property.
- You intend to use the money you take out to fund a high-return investment—a higher rate of return than the interest you’ll be charged on your new loan.
VA Loans: A Low-Cost Mortgage Option
If you (or your spouse) are an active member of the military or a veteran of military service, you may qualify for a VA loan. VA loans are one of the best benefits your service entitles you to. VA loans almost invariably come with lower interest rates. That’s because VA loans are guaranteed by the federal government and that makes them a low-risk proposition for mortgage lenders.
If your original mortgage was not a VA loan, by all means, look into making the switch. You can use your VA loan benefit over and over again, whether you move into a new home or refinance your existing loan.
Your Choice of Lender Can Lower Your Mortgage Costs
If your original mortgage was funded by a traditional bank or online lender, consider joining a credit union. Banks are for-profit institutions. Credit unions, by contrast, are not-for-profit entities. They’re beholden to their members, not to stockholders and corporate earning targets. Credit unions typically offer lower rates than private lenders. They may also have less stringent credit requirements, so if you’re having a tough time getting a loan from a bank, you may have better luck with a credit union. Credit unions are easy to join. Most simply require you to make a small deposit in a checking or savings account. Some are local so be sure to investigate institutions in your neighborhood. But some credit unions serve members nationwide.
Another Route to Consider: The Home Equity Loan
Using the refinancing strategies we’ve discussed so far, your lender will pay off your original mortgage, then issue you a brand new one. But there’s another solution you might consider if you’d like to take cash out of your home: a traditional home equity loan. When you take out a home equity loan, you’re not replacing your original mortgage, but rather taking out a second mortgage. You’ll have two monthly mortgage payments to make. But home equity loans offer a couple of advantages.
Your upfront costs may be lower with a home equity loan. Under certain circumstances, your lender may not require a home appraisal before offering you a home equity loan. You’ll save somewhere in the neighborhood of $400 if an appraisal isn’t required. If you’re taking out a home equity loan from the lender who holds your first mortgage, the institution may be less likely to require an appraisal. Your lender probably has a pretty good idea of what your home is worth. If you’re not taking out a large amount of equity from your home, a lender might consider it nominal enough to forgo an appraisal.
Your closing costs on a home equity loan may be lower than they’d be with a cash-out refi. But you can still expect to pay a small percentage of your total loan amount at closing. Some lenders assess an origination fee on home equity loans, though there are some no-origination-fee loans out there.
Another Second Mortgage Option
Home equity lines of credit (HELOCs) share some similarities with home equity loans. They are also considered second mortgages. And you can expect to pay the same origination fees. But unlike home equity loans, which pay you a lump sum when you close, a home equity line of credit is something you can draw on in increments. If you’re not sure how much cash you need to withdraw—for example, if you want to complete several home improvement projects over a long period, a home equity line of credit may be a smart choice. You’ll only pay interest on your outstanding balance and if you’re able, you can pay off your balance as you go. That can reduce the amount of interest you pay and still give you access to cash as you need it. HELOCs also offer another benefit. When you take out your loan, your lender will designate a draw period, during which you can take cash out, but not make monthly payments. That’s a key difference between a HELOC and a home equity loan, which requires you to make monthly payments the entire time you have a loan balance.
How To Secure a Lower Interest Rate on Your Loan
Why spend more money than you have to every month—or over the lifetime of your loan? A lower mortgage interest rate can help you cut a smaller check each month. How much lower? That depends on several factors.
How’s Your Credit?
Has your credit score improved since you took out your original mortgage? If so, you have a great chance of getting a lower interest rate on your new loan. In fact, the single most important influence on the mortgage interest rates you’ll be offered. If you haven’t checked your credit report lately, the time to do so is before you apply for a new loan.
Check Your DTI
If you’re earning significantly more than you were when you took out your original mortgage, that may also earn you a lower rate. Mortgage lenders look at your debt-to-income ratio when deciding what rate to offer you. They compare the amount you earn to the debt you’re currently carrying. The lower your DTI ratio, the safer you look to them as a borrower. Remember that lenders will consider not just the amount of money you owe on your home, but also your car loans, credit card balances, and other debts. So before you apply for refinancing, do your best to decrease balances on your other credit accounts. Paying down high-interest credit card debt should be a priority whether or not you’re applying for a mortgage. It’s just a smart financial move all around.
Your LTV Counts, Too
The real estate market is red hot right now. Nationwide, in 2021, home prices surged by an average of 20%. That means many homeowners were fortunate to recently gain instant equity in their homes. And home prices have increased steadily, if not so radically, for decades. If you’ve owned your home for some years or even a short time, it’s likely you’ve built up some significant equity. That can also help you lower the mortgage interest rates you’ll be offered. Mortgage lenders look at another ratio—your loan-to-value ratio (LTV)—when evaluating borrowers. That ratio compares how much you want to borrow to the value of the home that secures it. Even if you refinance the full amount you owe on your current mortgage, your LTV may be considerably more favorable now, which would typically qualify you for a lower mortgage interest rate.
Find the Right Refinancing Solution Summed Up
Mortgage refinancing can be complicated. But we’ve summed up our top tips for you to keep in mind as you’re exploring your refinance options.
- Consider your financial goals before deciding which type of refinancing is right for you.
- Approach multiple lenders, including credit unions, and compare offers before choosing a loan
- If you’re a veteran or active service member, explore a low-cost VA loan
- Carefully compare your current mortgage to the new mortgage offered to you taking into account upfront and closing costs. Figure out your break-even point with each loan you consider. Unless you plan on owning your home for a while, it may not make sense to refinance.
- Calculate both monthly mortgage payments and the lifetime cost of your loan to understand the full financial implications
- Do everything you can to improve your credit score and debt-to-income ratio before applying for a loan.
Susan Doktor is a journalist, business strategist, and principal at Branddoktor. She writes on a wide variety of topics, including real estate and personal finance. Her contribution comes to use courtesy of Money.com.