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Guide to Getting a Federal Housing Administration (FHA) Mortgage

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Not all homebuyers have the money to make a traditional 20% down payment. The perception that you need one is one of the main financial obstacles that can discourage people from pursuing homeownership.

In reality, there are several options for buyers who want to get a mortgage but can only pull together a small down payment. One of the best ones, particularly for first-time homebuyers, is an FHA loan.

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This article offers you a guide to getting an FHA mortgage, including details on how to qualify and the costs to consider.

What it takes to qualify for the FHA mortgage program

FHA mortgages are insured by the Federal Housing Administration (FHA), part of the U.S. Department of Housing and Urban Development. The program is a key way that people of moderate income can become homeowners. Nearly 83% of homeowners who borrowed an FHA loan in 2018 were first-time homebuyers, according to a report from HUD.

FHA mortgages are funded by FHA-approved lenders and then insured by the government. This backing protects lenders from loss if borrowers default. Because of this protection, lenders can be more lenient with their qualifying criteria and can accept a significantly lower down payment.

You can get approved for an FHA mortgage with as little as a 3.5% down payment and a credit score of 580. You may also qualify with a credit score as low as 500, though you’ll need to put down 10% instead.

On a $200,000 home, that comes out to a down payment of $7,000 to $20,000 when taking out an FHA loan, depending on your credit score.

Keep in mind you’ll also be responsible for closing costs, which typically cost 2% to 5% of a home’s purchase price. Closing costs are necessary to complete your transaction, and include services such as appraisals and home inspections. However, you may be able to negotiate to have some of these costs covered by the seller.

Is an FHA loan right for you?

FHA loans are particularly suited for several different types of homebuyers.

First-time homebuyers, who often have lower credit scores and smaller available down payments, tend to gravitate to FHA loans. Additionally, boomerang buyers — people who lost a home in the past due to a bankruptcy, foreclosure or short sale — might also benefit from an FHA loan.

Negative credit events such as foreclosure can drop credit scores by more than 100 points in many cases, and there’s typically a waiting period of three years before you’re eligible to buy a home again. Once that’s up, the lower credit score requirements of the FHA loan program could help you become a homeowner again.

Types of FHA mortgages

The FHA offers both 15- and 30-year mortgages, each with fixed rates or adjustable rates.

With a fixed-rate FHA mortgage, your interest rate is consistent through the loan term. You know what your principal and interest payment will be for the life of the mortgage. However, your overall monthly payment may increase or decrease slightly based on your homeowners insurance, mortgage insurance premium and property taxes.

Adjustable-rate FHA mortgages start out with a low and fixed interest rate during an introductory period of time, usually five years. Once the introductory period ends, the interest rate will adjust annually, which means your monthly mortgage payments may increase based on market conditions.

A unique situation where signing up for a low, adjustable-rate FHA mortgage could make sense is if you plan to sell or refinance the home before the introductory period ends and the interest rate changes. Otherwise, a fixed-rate FHA mortgage has predictable principal and interest payments and may be the better option.

FHA loan limits

The FHA imposes a limit on the amount of money that homebuyers are allowed to borrow each year. For 2019, the FHA loan limits for one-unit properties are $314,827 in most U.S. counties and $726,525 for high-cost areas. You can find your county’s loan limit information for one- to four-unit properties by using the FHA’s lookup tool.

Qualifying for an FHA loan

Credit scores

Besides the low down payment, an undeniable benefit of the FHA mortgage is the low credit score requirement. You may qualify for a 3.5% down payment with a credit score of 580 or higher. You can qualify with a minimum credit score of 500, but you’ll have to make at least a 10% down payment.

Debt-to-income ratio

Your debt-to-income (DTI) ratio is another key metric lenders use when determining whether you can afford a mortgage. DTI measures the percentage of your gross monthly income that is used to repay debt. Lenders consider two DTI ratios when determining your eligibility — the front-end (housing debt) ratio and the back-end (total debt) ratio.

Your front-end ratio is the percentage of your income it would take to cover your total monthly mortgage payment. Lenders typically like to see a front-end ratio of no more than 31%.

Your back-end ratio illustrates the percentage of your income that covers your total monthly debts. Lenders prefer a back-end ratio of 43% or less, but may approve a higher ratio if you have compensating factors, such as a higher credit score or a larger down payment.

You’ll also need to have a steady income and proof of employment for the last two years. Additionally, the home you’re purchasing via FHA must also be your primary residence, at least for the first year.

FHA mortgage insurance

At first glance, an FHA mortgage probably seems like the ultimate hack to buying a home with minimal savings. The flip side to this is you must pay mortgage insurance premiums (MIP) in exchange for your lower down payment.

Remember, FHA-approved lenders offer mortgages that require less money down and flexible qualifying criteria because the Federal Housing Administration will cover the loss if you default on the loan. The government doesn’t do this for free.

FHA mortgage borrowers must “put money in the pot” to cover the cost of this backing through upfront and annual mortgage insurance premiums. The upfront insurance premium costs 1.75% of the loan amount and can be rolled into your mortgage balance.

The annual mortgage insurance premium is divided into 12 installments and paid monthly as part of your mortgage payment. The annual premium ranges from 0.45% to 1.05%, based on your loan term, loan amount and loan-to-value ratio (LTV).

How your loan-to-value ratio affects mortgage insurance

Your LTV is a metric that compares your loan amount to your home’s value. It also represents the equity you have in the property. For example, putting 3.5% down means your LTV would be 96.5%. In other words, you have 3.5% equity in the home, and your loan is covering the remaining 96.5% of the home value.

Here’s the annual MIP on a 30-year FHA mortgage (for loans less than or equal to $625,500):

  • LTV over 95% (you initially have less than 5% equity in the home) – 0.85%
  • LTV under 95% (you initially have more than 5% equity in the home) – 0.8%

As you can see, starting off with a smaller down payment will cost you more in mortgage insurance premiums. Additionally, in most cases, you’ll pay annual MIP for the life of your loan.

However, if your LTV was less than or equal to 90% at time of origination — meaning you made a down payment of at least 10% — you can cancel MIP after 11 years.

FHA loans vs. conventional loans

Government-backed home mortgages like the FHA loan are special programs serving borrowers who might not qualify for a traditional mortgage.

Conventional mortgages are offered by lenders and banks and typically follow Fannie Mae and Freddie Mac’s mortgage standards. Fannie and Freddie are government-sponsored enterprises that buy loans from mortgage lenders and banks that fit their requirements.

The qualifying criteria bar for conforming loans is usually set higher. For instance, you typically need to have at least a 620 credit score to qualify for a fixed-rate conventional loan. However, credit score minimums vary by lender, but in any case, a score above 620 will be necessary for the most competitive interest rates.

A misconception about conventional mortgages is that borrowers must have 20% for a down payment to qualify. Mortgage lenders may accept less than 20% down for a conventional mortgage if you have a high credit score and pay their version of mortgage insurance premiums, which is called private mortgage insurance (PMI).

Similar to FHA mortgage insurance, PMI is a private insurance policy that protects the lender if you default. Be careful not to confuse the two types of insurance policies.

If you have PMI on a conventional mortgage, you’re able to request the removal of those insurance payments when you build up 20% equity in your home. On the other hand, the mortgage insurance premiums for most new FHA mortgages can’t be removed unless you refinance.

When to choose a conventional mortgage instead

Choosing an FHA loan can be a shortcut to homeownership if you don’t have much cash saved or the credit history to get approved for a conventional mortgage. Still, the convenience comes at a price that can follow you for the entire loan term.

Furthermore, putting a small sum down on a home means it will take you quite some time to build up equity. A small down payment can also increase your monthly payments and interest rate.

Homebuyers with a strong credit score should consider saving a bit more money and shopping for a conventional home loan first before thinking an FHA mortgage is the only answer to a limited down payment.

If you plan to put down at least 5% toward your home purchase and have a good or excellent credit score, it might make sense to borrow a conventional mortgage instead. A conventional home loan with PMI may not require the same upfront insurance payment as the FHA home loan, so you can find some savings there. Plus, you’re capable of getting rid of PMI without refinancing.

There are a few conventional mortgage programs that allow a 3% down payment, including Fannie Mae’s HomeReady program and Freddie Mac’s Home Possible program. These products also have cancellable mortgage insurance.

Shopping for an FHA loan

So, you’ve reviewed all the information and determined that an FHA loan is right for you. Once you’re ready to start the homebuying process, one of the most important things on your to-do list is shopping around.

Gather quotes from multiple FHA-approved lenders to find the most competitive rate. If you’re unfamiliar with the approved lenders in your area, you can use the HUD’s lender list search to locate them.

Comparison shopping for the best mortgage rate can save you thousands in interest over the life of your loan, according to research from LendingTree, which owns MagnifyMoney. Be sure you also compare the various other costs associated with borrowing a mortgage, including lender fees and title-related expenses.

Don’t rush to a decision. If you’re still not sure which mortgage type will be the most cost-effective for you, ask each lender you shop with to break down the costs for a comparison.

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Crissinda Ponder
Crissinda Ponder |

Crissinda Ponder is a writer at MagnifyMoney. You can email Crissinda here

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Mortgage

Bridge Loans: What They Are and How They Work

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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If you’re shopping for a home in a hot real estate market, you might find that sellers aren’t willing to wait for you to sell your home before you buy. In that case, a bridge loan can help you purchase your next home without the pressure of selling yours first.

Before you take the plunge into the bridge lending world, learn the ins and outs with this guide to understanding bridge loans.

What is a bridge loan?

A bridge loan is a short-term mortgage you can use to access equity in a home you are selling in order to purchase a new home. Bridge loans are commonly used in tight housing markets where bidding wars demand competitive purchase offers without any contingencies.

How does a bridge loan work?

Bridge loans work in two different ways — as a first mortgage to pay off your current loan and fund the down payment of a new house, or as a second mortgage, with the money applied to the down payment of a new home. Let’s explore how each of these work.

First mortgage bridge loan: One large loan is taken out for up to 80% of your home’s value. The funds are initially used to pay off the current mortgage balance. Any extra money leftover is used toward the down payment for your new home.

Second mortgage bridge loan: This option involves borrowing the difference between your current loan balance and up to 80% of your home’s value. The mortgage on your current loan is left alone, and the second mortgage bridge funds are applied to the down payment on the home you’re buying.

Here’s an example of how each option would look if your current home is worth $350,000 with an outstanding loan balance of $200,000, assuming you borrow 80% of your current home’s value.

Bridge loan optionMaximum loan amountHow funds are applied
First mortgage bridge loan$280,000$200,000 to current loan payoff

$80,000 to down payment new home
Second mortgage bridge loan$80,000$80,000 to down payment new home

Pros and cons of buying a home with a bridge loan

Pros

Tap home equity while your home is for sale. A bridge loan lets you tap the equity you’ve built in your current home while it’s for sale to buy a new home. Standard lending guidelines for conventional loans don’t allow cash-out refinancing on a property listed for sale.

Avoid making an extra move. A bridge loan allows you to move while your current home is still being sold so you’re not stuck finding a temporary place to live if you can’t time both sales perfectly.

Pay off the balance of your current loan and get extra cash. If you have a significant amount of equity in your home, you may be able to pay off your current mortgage while you wait for your home to sell. You can then use any extra cash toward a bigger down payment on your new home. This prevents you from paying two mortgage payments until your old home is sold.

Use bridge funds as a second mortgage to buy your new home. If your current mortgage rate is low, paying the entire balance off with a bridge loan doesn’t make sense. If you borrow the equity you have you in your current home as a second mortgage, you’ll have a lower bridge loan balance and payment.

Buy a new home without waiting for your current home to sell. A bridge loan eliminates the need for a home sale contingency, making your offer more competitive in a tight housing market.

Make interest-only payments until your home sells. Some bridge loan programs offer an interest-only option, which means you pay only the interest charges accruing each month. The interest rate may be slightly higher, but it will soften the impact of having two monthly mortgage payments.

Cons

You’ll make two or three mortgage payments. Once you borrow against your equity and buy your new home, you’ll be carrying at least two, possibly three monthly mortgage payments, depending on how you use the bridge loan. This can add up fast and become unsustainable.

Higher interest rates and closing costs. Like most short-term lending options, bridge loans come with higher interest rates and closing costs. Lenders charge higher rates and fees to make it worth their while because you are borrowing only for a short time. You might have trouble making the payments on both mortgages if you have a hard time selling your current home.

Increases the risk of defaulting on two mortgages. Bridge lenders expect you will be able to pay off the loan within a year. If the balance isn’t paid by then, they can foreclose on your home. As a result, your credit and finances will take a massive hit, and you might be unable to repay the mortgages on both homes.

Need substantial equity to qualify. Bridge loans are not a viable choice if you don’t have a good chunk of equity in your home. You can borrow up to 80% of the value of your home, so if you’re in an area where neighborhood values have dropped, you’ll want to come up with alternative financing.

Not as regulated as traditional mortgages. When regulatory reform was passed, it was intended to focus on long-term loan commitments to protect borrowers from taking out loans they couldn’t repay. The new rules don’t apply to temporary or bridge loans with terms of 12 months or less, meaning you’ll have less protection.

How to qualify for a bridge loan

Bridge loans are specialty mortgage loans, and they aren’t approved based on the same standards as a regular mortgage. Lenders that offer these loans have a few extra qualifying hoops for you to jump through, and rates and fees vary depending on property type, too.

Here are some key qualifying requirements unique to bridge loans:

Enough income to cover multiple mortgage payments

Bridge lending guidelines are often set by private investors or are specialized programs offered by institutional banks. That means they can create their own guidelines. Some bridge lenders may not count your current mortgage payment against you because they approve the loan knowing your intent is to pay it off quickly.

Other lenders will require you to qualify with both loans, which could mean you can’t tap into the full amount of your equity unless you have enough income.

At least 20% equity in your current home

Bridge loans work best if you have more than 20% equity, but the bare minimum requirement is 20%. If you don’t, it’s unlikely you’ll qualify for a bridge loan.

A commitment to paying off the loan quickly

Bridge lenders will scrutinize the home you are selling more than the home you are buying to make sure it’s priced to sell within bridge loan’s term period, usually 6 to 12 months. An appraisal will be required on your current home, and if the value comes in significantly lower than what your asking price is, your loan amount will be reduced.

Average closing costs for a bridge loan

Bridge loan closing costs typically range from 1.5% to 3% of the loan amount, and rates can be as high as 8% and 10% depending on your credit profile and how much you are borrowing. Beware of any lender that asks for an upfront deposit to approve a bridge loan; they probably aren’t a legitimate lending source and you should steer clear.

How to find a bridge loan lender

Bridge lending is a niche product, so not every lender will offer the option. You’ll need to shop around with mortgage brokers and institutional banks. Also, ask your current mortgage broker or loan officer whether they have experience closing bridge loans.

Work with a legitimate, licensed loan officer. You can check licensing requirements for all 50 states with the Nationwide Multistate Licensing System Consumer Access link. Type in your loan officer’s name or company information. Here are examples of lenders who may offer bridge loans:

Institutional lenders

Start with your local bank to discuss their bridge loan programs. If you have a substantial amount of deposits with a bank, the bridge loan terms might be more flexible and approval might go more smoothly.

Alternative lenders

Mortgage brokers and mortgage bankers often have relationships with alternative lenders. They can often find a bridge loan source if your current bank doesn’t offer them.

Hard money lenders

A hard money loan may be a good fit for bridge financing to purchase fix-and-flip investment property. Hard money lenders are often private investors, or groups of private investors, looking for high returns on short-term real estate loans. Interest rates can run into the double digits, and you can expect a prepayment penalty and fees range between 2% to 10%, depending on how risky your credit profile is.

Alternatives to using a bridge loan

You can do some advance planning to avoid needing a bridge loan, or at least limit how much bridge financing you need to purchase a home. Here are some other options to consider:

Use an existing home equity line of credit (HELOC)

If you already have a HELOC on your home before you start searching for a new home, you can use the HELOC toward a down payment on your new home. Typically there are no limitations on how you can use HELOC funds. A few drawbacks: You might have to pay a close-out fee when your home sells and the HELOC is paid off and closed, and you won’t get a mortgage interest tax deduction on the extra borrowed equity. You also risk losing your home if you can’t repay the loan because your home is serving as collateral for the loan.

Take out a 401(k) loan

Your retirement savings account can be another tool to bridge the gap in financing, and the rates and payment may be significantly less than what you’ll pay for a bridge loan. Check with your plan provider for any restrictions on loans for home purchases. It may be more cost-effective to take out a 401(k) loan to avoid the closing costs and high interest rates that come with a bridge loan.

The drawback to a 401(k) loan is that the borrowed money is taken from your retirement savings and won’t be working for you in the market. Consider this option only if you plan to repay the loan immediately after your current home sells.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Denny Ceizyk
Denny Ceizyk |

Denny Ceizyk is a writer at MagnifyMoney. You can email Denny here

By clicking “See Rates”, you will be directed to LendingTree. Based on your creditworthiness, you may be matched with up to five different lenders in our partner network.

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How to Refinance Your Mortgage to Save Money and Consolidate Debt

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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Refinancing your mortgage, which is the process of paying off your existing home loan and replacing it with a new loan, can save homeowners money. But before you consider a mortgage refinance, you should understand how much it costs and what the process entails.

In this guide, we’ll explore how to refinance a mortgage, how much it costs to refinance and how to decide whether you should refinance at all. We’ll also discuss the refinancing process and offer comparison-shopping tips.

How to refinance your mortgage

Before we cover the steps you need to take to refinance a mortgage, we first need to understand the different refinance options available. Below is a table of the types of refinances and the process involved for each in refinancing your mortgage.

Types of mortgage refinances

Refinance Type

How Does It Work?

Cash-out A way to borrow against your available equity. You take out a new mortgage with a larger balance than your existing loan and pocket the difference in cash.
Limited cash-out The refi closing costs and fees are financed into the new loan, and you may receive a small amount of cash — not to exceed 2% of the loan amount or $2,000, whichever is lower — when the closing documents are reconciled.
No cash-out Also called “rate-and-term” refinance. You refinance your existing loan balance to improve your loan terms by securing a lower mortgage rate or switching mortgage types, for example. You can either pay your closing costs and fees out of pocket or finance them into your new loan.
Streamline A refinance with limited documentation and underwriting requirements. The goal is to lower your monthly mortgage payment. Streamline refinances are available on government-backed mortgages through the FHA, USDA and VA.

Step-by-step guide to shopping for a mortgage refinance

Before you start shopping for a new mortgage, arm yourself with knowledge. First, check mortgage refinance rates in your area online.

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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 refinance, pull a copy of your credit report from each of the three major credit reporting bureaus — Equifax, Experian and TransUnion. Review your reports for accuracy and dispute any errors you find. You’ll also want to access your credit scores to see where you stand.

Aim for a score of 740 or higher to qualify for the lowest mortgage rates. You can still qualify with a lower credit score, but the lower your score, the higher your interest rate will be. We offer separate tips on how to refinance a mortgage with bad credit.

Choose your rate type
Decide which rate type works for you. For example, do you have an adjustable-rate mortgage and want to switch to a fixed-rate mortgage? Mortgage rates might be lower now, but eventually they’ll increase. If you have a 5/1 ARM, your mortgage rate is fixed for the first five years, but will adjust annually thereafter. Unless you know with certainty you can afford your monthly payments when your rate starts rising, or you aren’t planning to stay in the home for long, an ARM is risky.

If you don’t want to gamble with your monthly mortgage payment, stick with a fixed-rate mortgage. Your rate will be locked in for the life of your loan.

Gather multiple quotes

As with most shopping endeavors, the best way to find the best price is to get quotes from multiple mortgage lenders in your area.

There are two primary criteria for you to consider. The first, of course, is interest rates. The second is fees, which can eat into your savings.

It’s easy to take the path of least resistance and refinance with your current lender, which may offer you lower fees than their competitors. But the interest rates offered by your current lender may be higher than what’s available with other lenders. Get outside quotes to use as leverage for negotiations.

Or maybe your lender is offering you lower fees and interest rates than the competition, but the rate is still higher than you’d like it to be because of a less-than-perfect credit score. While doing so doesn’t have a high success rate, you can try negotiating for a lower rate based on customer loyalty.

Prepare your documents

Gather these commonly required documents before approaching your lender to ensure the application process goes as smoothly as possible:

  • Personal information: Be prepared with your Social Security number, driver’s license or other state-issued ID, and the addresses you have lived at for at least the past three years. Lenders are required to verify your identity before lending you any money or allowing you to open any type of financial account.
  • Accounting of debts: Statements for any outstanding credit card balances or loans you may have, including your current mortgage.
  • Proof of employment and income: Last two to three 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 schedules and profit/loss statements.
  • Proof of assets: A list of all the properties you own, life insurance statements, retirement account statements and bank account statements going back at least three months.
  • Proof of insurance: This generally refers to homeowners insurance and title insurance.
  • Additional documents: If you receive income from disability, Social Security, child support, alimony, rental property, regular overtime pay, consistent bonuses or a pension, be sure to provide 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.

Apply for the refinance

Once you’ve done your homework and gathered all your information, apply for the refinance with the lender you’ve selected.

How long does it take to refinance a mortgage?

The full process of being approved for a mortgage refinance typically takes between 20 and 45 days if you submit your paperwork in a timely manner. It will require hard pulls of your credit reports and scores, along with the submission of personal documentation.

Approval
A loan officer will look over your paperwork, which will hopefully end in approval. You’ll then be sent documents to review. It would be wise to do so with a lawyer, which is an additional fee you’ll want to consider as part of your refinancing costs.

Closing
If everything checks out and you agree to your new loan terms, then it’s time to finalize the deal with your mortgage closing. If you didn’t finance your closing costs and fees as part of your new loan, you’ll pay for them at closing time. Depending on the lender, you’ll sign your documents 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.

Should you refinance your mortgage?

There are many reasons you might consider refinancing your mortgage. For example, interest rates could have dropped significantly since you first bought your house. You may also have a growing list of home repairs that need to be addressed, or high-interest credit card or student loan debt to consolidate, and a refinance can help you achieve those goals.

But are any of these good reasons to refi? To decide, you need to factor in the cost of refinancing a mortgage, along with some other considerations. We’ll weigh the pros and cons of refinancing for various goals below.

Refinancing to lock in a lower mortgage rate

Mortgage interest rates have been historically low for a while. As of mid-September 2019, the average interest rate on a 30-year fixed-rate mortgage was 3.56%, according to Freddie Mac’s Primary Mortgage Market Survey. During the same week in 2018, the average rate was 4.6%. If your original mortgage rate is higher than 4%, it might make sense to explore your refinance options, since a lower interest rate can save you money over time.
See the table below for an illustration of how a lower interest rate can reduce the overall cost of your mortgage.

 Existing mortgage New mortgage

Loan amount

$290,921.36 $290,921.36

Years remaining on term

28 years 30 years

Interest rate

5%4%

Monthly payment
(principal and interest)


$1,610.46 $1,388.90

Total interest paid
(over 30 years)


$279,767.35 $209,083.75

Let’s say you’re refinancing a 30-year mortgage you undertook two years ago, and you now qualify for a mortgage rate that’s a full percentage point lower than your current rate — you’re going from 5% to 4%. Although a refinance will mean it will take longer to pay off your loan, the trade-off is the money you’ll save. Based on the table above, your new mortgage rate would lower your monthly payment by $221.56 and cut down your interest payments by more than $70,000 over the life of the loan.

How much does it cost to refinance a mortgage?

The savings sound promising, but hold your enthusiasm. Don’t forget to answer this key question before moving forward: How much are the closing costs to refinance a mortgage?

A refinance comes with closing costs and fees that could range from 3-6% of the new loan amount. Charges usually include escrow and title fees, document preparation fees, title search and insurance, loan origination fees, flood certification and recording fees. On a nearly $291,000 mortgage, these expenses could add up to more than $8,000 or more.

In order to truly save money through refinancing, you’ll need to determine your break-even point, which is the amount of time it will take for your monthly payment savings to cover the costs you paid for the refinance. Using the numbers above, we would need to divide the estimated closing costs — let’s just use $8,000 in this example — by the $221.56 monthly payment savings. The math tells us it would take about 36 months — or three years — to break even. If you don’t plan on staying in your home for at least three years or longer, you should probably keep your existing mortgage.

Refinancing to lower your mortgage payments

If you’re thinking about refinancing to lower your monthly mortgage payments, you should understand that while you’ll pay slightly less every month, the amount you pay over the life of your loan will increase.

Refinancing simply to lower your monthly payment can be dangerous during the first five to seven 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 those first several years, you’re paying more toward interest than your 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.

Revisiting our previous example, let’s say instead of refinancing your 30-year, $300,000 mortgage after a couple of years, you waited until you were 10 years into the loan to refinance. Your goal is to lower your monthly mortgage payment, but in order to get the payment as low as you want, you extend your loan term by 10 years and start over with a new 30-year mortgage.

On your existing mortgage, nearly $600 of your monthly payment goes toward paying down your principal by year 10. If you were to start over, the amount you’d pay toward principal drops down to less than $400 for the first few years.

Refinancing to make home improvements

Some homeowners choose to pay for home improvements by refinancing a mortgage, especially if they don’t already have the cash on hand.

Cash-out refinance

One way to do that is through a cash-out refinance, which is when you borrow a new mortgage with larger balance than your existing mortgage. The difference between the two loans is given to you in cash. That available cash comes from the equity you’ve built from paying down your existing mortgage.

A cash-out refinance could work for you if you have built a significant amount of equity in your home. Most lenders limit the maximum loan-to-value ratio — the percentage of your home’s value that is financed through your mortgage — for cash-out refinances to 80%.

Choosing a cash-out refinance could make more financial sense than borrowing a personal loan or putting repairs on a credit card, since refinance interest rates are typically lower than those alternatives.

HELOC

Another option is to borrow a home equity line of credit (HELOC). This functions similarly to a credit card; you have a line of credit up to a set amount and only pay for what you borrow, plus interest. However, because a HELOC is secured by your home, interest rates are typically much lower than on credit cards. However, rates are generally variable and not fixed, which could cause problems later if you’re carrying a large balance on your HELOC and interest rates go up.

HELOCs usually have a draw period, when you’re allowed to borrow against the credit line, and a repayment period, when you can no longer borrow and are only repaying what you owe. During the draw period, the required minimum payments usually just cover the interest, but during the repayment period, you’ll have to make principal and interest payments that will likely be much higher than your interest-only payments — especially if your outstanding balance is high.

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. If you’re thinking about tapping your equity to pay for a major project that may not boost your home’s value, it might not be wise to do so. If the luxury is something you really want, don’t finance it — save up for it.

Refinancing to consolidate debt

You might be tempted to use a cash-out refinance to pay off credit card balances or other high-interest debt. With mortgage interest rates hovering near historic lows, taking this route may seem like a good idea. After all, rolling your debt into a mortgage with a 4% interest rate is better than paying it off at 15% interest or higher, isn’t it?

Credit cards

There are some instances where rolling your credit card debt into a mortgage refinance can be advantageous. For example, if you’re in a dual-income household and you lose a spouse without adequate life insurance, you may find yourself in a financial bind.

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 debt may be one of the few feasible options.

Let’s say you owe $20,000 in credit card debt at a 15% interest rate. If you pay off that balance over the next five years, you’ll pay more than $8,500 in interest. However, if you add that same balance to a mortgage with a 4% interest rate, although you’re increasing your loan amount, you’ll likely pay less interest than if you kept the debt on your card.

Outside of scenarios similar to the one mentioned above, refinancing your mortgage to consolidate credit card debt often doesn’t get to the root cause of the issue. If you had a spending or cash flow problem prior to your mortgage refinance, you’re likely to end up in debt again. But this time, you’ll have a bigger mortgage to handle on top of the extra debt.

Instead of borrowing a bigger mortgage to get rid of your credit card debt, consider applying for a balance transfer credit card. Though these cards come with balance transfer fees, they can be as low as 3%, and you only have to pay them once. Many cards include an initial 0% interest offer on balance transfers for the first 15 months or longer. Because there is a deadline on the 0% interest period, you’ll likely find the motivation to pay the debt off quickly and build better financial habits along the way.

Student loans 

If you have student loan debt that could take decades to repay, refinancing your mortgage to access the cash you need to pay off that debt could potentially be a smart idea.

Fannie Mae, one of the two mortgage agencies that buy and sell mortgages from lenders that conform to their guidelines (the other agency is Freddie Mac), has a “student loan cash-out refinance” option that allows borrowers to refinance their mortgage and cash out a portion of the new mortgage to pay off 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 new $50,000 mortgage, with $20,000 of it paying off your debt.

Going this route could make sense if the interest rate on the refinance is less than the interest rate on your student loans. Additionally, if you sell your home, the proceeds should take care of the portion of your mortgage that was dedicated to paying off your loans.

The drawback of refinancing to consolidate or pay off debt is that not only do you increase your mortgage balance — you lose your available equity. Be sure to weigh the pros and cons before tapping your equity.

The bottom line

A mortgage refinance can save you money, cut down on your interest payments or give you access to cash, but be sure you’re clear on why you’re refinancing and whether it makes sense.

If you’re refinancing to extend your loan term by several years and dramatically lower your mortgage payments, or remodel your kitchen to something of a chef’s dream, reconsider. But if you’re looking to snag a lower mortgage rate on a loan for which you’ve built significant equity, refinancing may be beneficial.

Before signing on any dotted lines, reach out to your loan officer, ask questions and run the numbers.

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Crissinda Ponder
Crissinda Ponder |

Crissinda Ponder is a writer at MagnifyMoney. You can email Crissinda here

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