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What to Know About Getting a Mortgage on a Second Home

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Although 36 percent of investors and 29 percent of vacation home buyers pay cash for their properties, many finance their homes, according to a survey by the National Association of Realtors Research Department. But even buyers who finance their second homes have a lot of cash on hand: 47 percent of investors and 45 percent of vacation home buyers finance less than 70 percent of the home’s purchase price.

That’s not to say you can’t get a second home with a smaller down payment, but it’s one of many important things to think about when looking to get a mortgage on a second home.

Is buying a second home right for you?

Before making a huge financial commitment like this, make sure you ask yourself these crucial questions:

Can I afford a second home?

Many families love the idea of buying a second home, but think about all the costs you incurred when buying your primary residence:

  • Down payment
  • Closing costs
  • Monthly mortgage payment
  • Property taxes
  • Property insurance
  • Private mortgage insurance (PMI)
  • Utilities
  • Landscaping and upkeep

You’ll incur many of these same costs with a second home, too. For example, Doug Crouse, a senior loan officer with nearly 20 years of experience in the mortgage industry, says PMI can be especially costly: “When it comes to second homes, PMI rates are about 50% higher than what they would be for a primary residence.”

However, a second mortgage isn’t inherently more expensive than a first mortgage. Dan Green, founder of Growella and a former top producing loan officer with 15 years of mortgage lending experience, says, “There is no closing cost difference on a second home [or] vacation home mortgage as compared to a primary residence.”

Keep in mind that if your second home is in a faraway location, you have to consider the long-distance costs of upkeep.

Will this be a vacation rental or an investment property?

There are typically two reasons people want to purchase a second home: buying it as a vacation home or buying it as an investment property. How you use it will have implications for your taxes.

According to the IRS, your home is a vacation home if you spend the greater of 14 days a year or 10% of the time you rent it to others.

Keep in mind that if you use your home solely for your family to vacation there, you can’t deduct items on your tax returns like utilities and real estate taxes like you would if it was an investment property. While you can deduct mortgage interest on a vacation home like you do for your first home, the new tax law for 2018 only allows you to deduct mortgage interest on your total properties up to $750,000. So if you already own a $750,000 home, you would not be able to deduct your mortgage interest on a second home.

If you use your second home to generate income from rent, you may be able to deduct items on your tax returns like utilities, real estate taxes, the fees you pay your property manager and more, according to the IRS. (Think of it like being a business owner who gets to deduct business expenses versus a vacation home owner.)

If you don’t want to choose between your second home being a vacation home or being an investment property, you don’t have to. It can be used as both, but you have to keep impeccable records that show when it’s being used and how, so you can properly itemize your deductions. For example, if you use it for half the year as a vacation home and rent it out the other half of the year, the IRS says you can only deduct your utilities, etc., on your taxes for the portion of the year you’re treating your home as a business and renting it out. It’s a good idea to consult a tax professional about how such an investment will affect you before you commit to buying a second home.

Is a second home a good investment?

Whether or not a second home is a good investment depends on the individual. Roger Wohlner, a fee-only financial planner, says, “One should be buying a second home for a specific reason such as a family gathering spot, an affinity to a location (a lake, etc.) or some other reason. Because of that, it can’t really compare to another investment.”

In other words, you can’t quantify relaxation, memories or family time as part of a return-on-investment calculation. That’s why it’s crucial you make sure you can afford the second home from the get-go.

If you’re considering a second home strictly as an investment property, whether or not it’s a good decision depends on many other decisions you make along the way, like how much you choose to charge in rent, which improvements you make to the property and how you plan to manage the property, to name a few. Before you decide to rent out an income property, make sure you’ve considered these seven major cost areas.

How to get a mortgage on a second home

What’s the difference between your primary mortgage and your second home mortgage?

There are a few differences between these two mortgages. Depending on your credit score and other qualifications, you may be able to get a conventional mortgage for a primary residence with as little as 3 percent down (but you will have to pay private mortgage insurance, or PMI.) You might also qualify for an FHA loan with 3.5 percent down. Generally, the higher your credit score, the better interest rate you will qualify for, but lenders may consider your application with a 620 or lower credit score. (You can read more here about the most important factors in getting approved for a mortgage.)

For a second home, you could be required to put 10 percent to 30 percent down, depending on your credit or debt to income ratio. Lenders like to see cash reserves, as well, to show that you can cover one to 12 months of payments. Additionally, lenders like to see a 640-700 credit score for second homes, and your interest rates might be a quarter of a point to a half a point higher than your primary mortgage, although Green says, “Mortgage rates on second homes may be slightly higher, or may not be higher at all.”

When it comes to credit qualifications for a second home, Crouse says, “Second home credit requirements are typically the same as primary residence for conventional lending.” Additionally, he says there’s no difference in the approval process. Green corroborates this. He says, “Minimum credit score thresholds aren’t usually different for vacation homes as compared to primary residences. However, lenders often ask for additional monies down.”

If you want to find a mortgage for a second home, Crouse says, “Typically lenders who offer primary home loans would also offer second home financing.” Green advises, “The mortgage-comparison process is the same. Do your research, talk to two or more lenders, and choose the lender that works best for you.”

You’ll also want to ask yourself these questions in order to avoid common mistakes:

Can I really afford this place? Wohlner says, “If you don’t have the cash for the down payment on a second home you shouldn’t be buying one.”

What loan terms make the most sense for this property? Just because you have a 30-year fixed-rate mortgage on your primary residence doesn’t mean that’s the right choice for a second home. Crouse says, “A common mistake is not looking at adjustable rate loans as an option,” because second homes are often “a luxury item and therefore something people liquidate when there is a change financial situation.”

Have I explored all my options? Green says, “When you’re shopping for a mortgage on a second home, make sure to actually shop.” He adds, “You’re looking for the best combination of price and service on your loan. It’s good to shop around.”

What are some ways to pay the down payment on a second home?

The best way to pay for a down payment on a second home is to pay for it with cash. Crouse says, in his experience, most people use cash as their down payment on second homes. The reason, he says, is, “Most buyers don’t want to tie up personal residence equity into their second home.”

If you don’t have the cash on hand and you’re committed to buying a second home, you can consider taking out a HELOC on your primary residence and using that money for the downpayment for your second home.

Taking out a HELOC comes with risks, though. You are leveraging your primary residence to purchase a second residence, which could cause you to lose your home if you fail to make your HELOC payments. In fact, Wohlner completely advises his financial planning clients against getting a HELOC to pay for a down payment on a second home. He says you should pay for it in cash.

Alternatives to mortgages for a second home

Getting a mortgage for a second home isn’t the only way to get the vacation property or investment property you want. Here are some other options:

Pay cash

Paying cash for your second home is a great way to ensure you don’t pay interest to a bank. It also means you’ll have no monthly mortgage payments on your second home, and that’s a great feeling. Of course, you’ll no longer have easy access to that money in case of an emergency. You might also prefer to get a mortgage at a low-interest rate and instead invest your cash in the stock market. Again, this is up to you, your risk tolerance and your cash reserves.

Get a joint mortgage with family

Sharing a second home and getting a mortgage with a family member could be a great way to split the costs and responsibilities of having a second home. Of course, involving multiple applicants in the mortgage process may make it a bit more logistically challenging.

You should also know that there are tax implications. When claiming the mortgage interest deduction, you may have to include an attachment in your tax return showing how much of the mortgage interest you paid. If you’re the person who receives the Form 1098 (the mortgage interest statement), you will deduct only the portion you paid and have to let the other borrowers know what their shares are.

Timeshare

Timeshares are an $8.6 billion industry, and the average price of a timeshare interval is $20,040, according to the American Resort Development Association. (A timeshare interval is the set number of days and nights per year an owner uses the property, usually a week, according to the ARDA.)

Now, you can go to large, well-known companies like Disney to find your own timeshare. With a timeshare, you typically get to visit a specific place every year for a set amount of time, like one week. So, you don’t have the flexibility of getting to visit your second home any time you want, but it can be more cost-efficient. Another con is that timeshares come with hefty dues that can increase each year.

Bottom line

Ultimately, buying a second home is an exciting prospect. If you vacation often to the same place, it can be a great way to become an official part of that community. However, buying a second home is a serious financial commitment that requires a large down payment and other maintenance costs. Luckily, if you decide you aren’t ready to buy a second home yet, you can still use vacation rental websites and continue to try new locations until you’re finally ready to take the plunge.

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.

Cat Alford
Cat Alford |

Cat Alford is a writer at MagnifyMoney. You can email Catherine at [email protected]

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Bridge Loans: What They Are and How They Work

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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

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How to Refinance Your Mortgage to Save Money and Consolidate Debt

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Happy black couple standing outside their house

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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