According to the Consumer Financial Protection Bureau, mortgage lending between August and October 2016 was up nearly 50 percent over last year, "unusually large number likely due to a high rate of mortgage refinancing."
There are many reasons you might consider refinancing your mortgage. For one, interest rates are continuing to creep up after several years of historic lows, driving many borrowers to refinance in hopes of locking in a lower rate now.
You may also have a long list of home repairs that need to be addressed. Cashing out on a refinance could provide you find the money you need to get the job done. You might also consider a mortgage refinance to help consolidate some of your high interest debt from credit cards or student loans.
But is any of this a good idea?
Today we’ll explore when refinancing a mortgage is a smart decision, and when it’s mathematically unwise. We’ll do this by looking at the cold, hard numbers and walk you through the process if you decide it is an avenue you’d like to pursue.
Refinancing to Lock in a Lower Mortgage Rate
As of this posting, the national average interest rate is at 4.15%. While that number is higher than it has been in the recent past, rates are still much lower than the average 6% rate you would have secured before the 2008 recession or the 10% average rate you would have had to pay in the 1980s. If you originally financed or refinanced your mortgage prior to the recession, exploring refinance options could be a good path for you.
However, before you decide on interest rates alone, you need to be aware of all the associated fees that come along with a refi. These fees usually include escrow and title fees, document preparation fees, title search and insurance, loan origination fees, flood certification, and recording fees. These alone can easily add up to $4,700 or more, according to Trulia.
Do the math
Because each situation will have varying interest rates and fees, it’s important to run your own numbers before making a definitive decision. While we can’t run your numbers for you, we can take you through the mathematical process through an example. You can do the same by using your own, real-life numbers and this calculator from myFICO.
Let’s say you’re refinancing a 30-year mortgage with a 5.4% interest rate. You have been paying your mortgage for 10 years at this point. But today, you still have $205,285.94 to pay off. If you continue to pay on your current mortgage, you will pay it off in 2036 but you will have paid a staggering $255,377.71 in interest fees over the lifetime of the loan.
So you are considering a refi loan. Let’s say you prequalify for a 3.5% fixed mortgage refi rate over an additional 30 years.
If you decide to refinance to a 30-year mortgage, it will be like starting the clock over even though you already paid 10 years into your original loan. So, factoring in the total interest you paid over that 10 year period on the original loan and the interest you will accrue over the 30-year span of the new refi loan, you will pay a total of $251,720.
By refinancing, it looks like you will pocket $3,657.71 in savings. So refinancing is definitely the better option, right?
Hold your enthusiasm. Remember those fees that come along with a refi? Before you can actually refinance your existing mortgage, you could face an estimated $5,077 in fees, MyFICO’s calculator shows. With the additional interest and fees combined, you’ll end up paying $256,797 over the lifetime of the loan — about $1,000 more than you would if you just stayed put.
That makes this particular refinance over $1,000 more expensive than continuing with your current mortgage. Plus, if you refinance, you’ll be paying on a mortgage for an additional ten years before you own your home outright.
Refinancing to Lower Your Monthly Mortgage Payments
If you already have a low interest rate and are thinking about refinancing exclusively for lower monthly payments, think again. While the amount due monthly will go down, the amount you pay over the life of your loan will go up.
In our example above, refinancing to a lower rate of 3.5% would dramatically decrease your monthly mortgage payments before taxes — from $1,403.83 per month to $922 per month. However, as we demonstrated using myFICO’s refi calculator, you’d end up spending $1,000 more over the course of the loan as a result.
Refinancing simply to lower your monthly payment is especially dangerous if you are in the first 5-7 years of paying off your current mortgage. That’s because interest charges are not spread out evenly over the course of your loan — they are front loaded. That means for the first 5-7 years, you’re paying more toward interest and very little toward the principal loan balance. In the meantime, you’re building very little equity. If you refinance during this time frame, you’re starting the clock over and delaying the opportunity to establish equity.
Suggest: Let’s back to our first example one more time. In this case, the homeowner is 10 years into their existing mortgage and has been making monthly payments of $1,403.83. By this time, roughly $477.89 goes toward the principal loan balance each monthly. But if they were to restart the clock and refinance to a new 30-year mortgage, only $325 of their monthly mortgage payment would go toward their loan principal.
Refinancing to Make Home Improvements
If you’re looking to refinance so you can cash out a portion of the new mortgage for home improvements, you may be onto a good idea. If you have a 20-year-old roof that needs to be fixed and no cash on hand, refinancing at at a lower rate could make more financial sense than using alternative financing options.
When you use a cash-out refinance, your financial institution will give you a new mortgage. Part of your monthly payment will go towards the amount you still owe on the home, while another part will go towards paying off the cash they give you at closing. You can usually only take 80%-90% of your established equity out as cash when using this method.
Another option is to take out a home equity line of credit (HELOC). This operates similarly to a credit card; the financial institution offers your a line of credit up to a specified amount, but you only have to pay on it if and when you choose to borrow. Because a HELOC is secured by your home, interest rates are much lower than on credit cards and may even be lower than the interest rate on a cash-out refinance. However, HELOC interest rates are typically variable, which could get you in trouble further down the line if you’re borrowing a lot of money for home repairs like a new roof.
Either way, you should be cautious. Making an upgrade for the sake of functionality is one thing, but making an upgrade for the sake of luxury is another. It’s inadvisable to make a lavish kitchen upgrade in the tens of thousands, even if you are under the illusion that it will build home value further down the line. If the luxury is something you really want, save up for it. Don’t finance it.
Refinancing to consolidate existing debts
Cashing out to pay off credit card debt
You may also be tempted to cash out a refinance in order to pay off other debt. Historically, homeowners have used this method primarily to pay off high-interest credit card debt. With interest rates so low, doing so may seem like a good idea. Rolling your credit card debt into a mortgage with 3% interest is better than paying it off with an average of 15%-25% interest — isn’t it?
It may seem like a good idea, but too often this method doesn’t change the root cause of the issue. If you had a spending or cash flow problem prior to the refinance, you’re likely to end up in credit card debt again, but this time you’ll have a bigger mortgage on top of it.
A better way to refinance your credit card debt could be applying for a balance transfer. Many credit cards include an initial offer of 0% interest on balance transfers for a certain amount of months. Zero percent is better than any interest rate you’ll find in the housing market. Though these cards come with balance transfer fees, those fees can be as low as 3%, and you only have to pay them once. Because there is a deadline on the 0% interest period, you’ll be more likely to find the motivation to pay the debt off quickly, building better financial habits along the way.
There are rare instances where rolling your credit card debt into a mortgage refinance can be advantageous. For example, if you’re a dual-income household and you lose a spouse without adequate life insurance, you may find yourself in a financial quandary.
In this scenario, if you have credit card debt in your own name and suddenly can’t afford to pay the monthly bills, refinancing your mortgage and cashing out a portion to pay off your high-interest debt may be one of the few feasible options.
Cashing out to pay off student loans
Recently SoFi, an online market lender, rolled out a new product that allows you to refinance your home and cash out a portion of the new mortgage to pay off your student loans. Let’s say you owed $30,000 on your home and had $20,000 in outstanding student loan debt. You would take out a $50,000 mortgage refinance with $20,000 of it paying off your student loan debt.
This can potentially be a smart idea. If the interest rate on the refinance is less than the interest rate on your student loans, you stand to save some money. If you ever sell your home, the sale will take care of the portion that went to pay off your loans.
The danger is you will lose all the benefits that come with federal student loans, such as income-based repayment and pay-as-you-earn options, as you will be swapping your Federal loans for a private loan issued by SoFi. For this reason, the vast majority of people who will benefit from this product will be those who already carry private student loans with relatively high interest rates.
How Should You Shop?
Before you start shopping, you’re going to want to arm yourself with knowledge. First, find out what competitive interest rates look like in your area. You can do so by using this tool from the Consumer Financial Protection Bureau.
It’s good to know what the best rates are, but it’s even better to know if you’ll qualify for them. About six months before you plan on applying for a refi, get a free copy of your credit report from each of the three credit reporting bureaus to make sure everything on your report is accurate and up to date. Your credit report will be used to determine your credit score when you start submitting applications.
Many conforming loans will be backed by Fannie Mae’s Refi Plus program. To qualify for the lowest interest rates in this program, you will want to have a credit score of 740+. You can still qualify with a lower credit score, but the further down you are on this list, the higher your interest rate will be:
- 740+ Best rates
- Below 620 Worst rates, and you may have trouble even qualifying.
To find out which credit score range you fall into, pull your scores from several different sources using several different scoring models.
Variable vs. fixed rates
Another thing to consider before you shop is whether you prefer a variable or fixed rate. Variable rate loans are stable for one month to five years or more, after which the interest rate will adjust based on an index. Since rates are low at the current moment, the odds of your interest rates shooting up after five years is extremely high. Unless you know with certainty that you can afford your monthly payments when they rise, or you aren’t planning to stay in the home for long, taking this route is risky.
Because rates are so low, fixed is likely the way to go. The rates will be higher than the offers you receive for initial variable rates, but they will stay consistent for the entirety of your loan. When interest rates inevitably go up again, yours won’t if you lock in the fixed rates today.
Shop around — including your current lender
As with most shopping endeavors, the best way to find the best price is going to be getting quotes from several different lenders in your area.
There are two primary criteria you will want to examine. The first is obviously interest rates. The second is fees, which can eat into your savings.
When you start shopping, it’s easy to take the path of least resistance: your current lender. Typically, they will offer you lower fees than their competitors, but their interest rates may be potentially higher. Get outside quotes to use as leverage for negotiations in this arena.
Another possibility is your lender offers you the smallest fees and lowest interest rates among their competition, but the rate is still higher than you’d like it to be because of your credit score. While doing so doesn’t have a 100% success rate, you can try to negotiate for a lower rate based on customer loyalty.
When you’re applying, don’t forget to look at online marketplace lenders such as SoFi. Many times they have lower fees and involve less paperwork.
How Long Does the Process Take?
Many lenders will want to see if you are pre-qualified before you begin the full application process. This can be misleading because getting pre-qualified often takes mere minutes, and the interest rates you are offered are based only on a soft pull of your credit.
The full process of being approved for a loan will take much longer--typically between 30 and 45 days if you submit all of your paperwork in a timely manner. It will require a hard pull on your credit report and score, along with submitting a lot of personal documentation. Remember, just because you are pre-qualified doesn’t mean you will be approved. Once the financial institution has more information, they may adjust or redact their offer.
Paperwork to prepare
To make sure the application and approval process goes as smoothly as possible, gather up these commonly required documents before approaching your lender to fill out any forms:
- Proof of income, including: past 2-3 months’ worth of pay stubs, employer contact information including anyone you’ve worked for in the past two years, W-2s and income tax documents for the past two years, and/or additional documentation of income for the past two years for self-employed individuals including Schedule C or K and profit/loss statements.
- Proof of assets, including: a list of all the property you own, life insurance statements, retirement account statements, and bank account statements going back at least three months.
- Accounting of debts. This includes statements for any outstanding loans or credit card debt you may have. Don’t forget your current mortgage!
- Proof of insurance. For our purposes today, this generally refers to homeowner’s insurance and title insurance.
- Know Your Customer information. Financial institutions are required to verify your identity before lending you any money or allowing you to open any type of financial account. Be prepared with your Social Security card, your driver’s license or other state-issued ID, and the addresses you have lived at for at least the past three years, including dates of residence.
- Additional documents for special situations. If you receive income from disability, Social Security, child support, alimony, rental property, regular overtime pay, consistent bonuses, or a pension, be sure to prepare documentation for these income sources as well.
There may be additional documents required depending on your lender, but checking off this list is a great start.
If you have all necessary paperwork on hand, you can submit it via the internet or postal mail immediately after filling out your application online, over the phone, or in person. The modality of submission will depend on the lender.
A loan officer will look over your paperwork, which will hopefully end in approval. You will then be sent documents to review. It would be wise to do so with a lawyer, which is an additional fee you will want to calculate into your refinancing equation.
If you are agreeable to all terms, you will fill out your documentation for closing. You will have to issue payment for closing fees just as you did when you took out your original mortgage. Depending on the lender, you will submit this paperwork in person, through postal mail, or online. After the paperwork is processed, your current mortgage will be paid off and your refinanced mortgage will take effect.
Typically, the entire process takes somewhere between 30 and 45 days. >
If you’re refinancing solely for lower mortgage payments or in order to cash out for a chef’s dream kitchen, back up and reconsider. But if you’re refinancing for lower interest rates on a mortgage on which you’ve built significant equity, moving forward may be a good option. Be sure to run your numbers and sit down with a lawyer before signing on any dotted lines.