Unless you had the resources on hand to buy your home using cash (which is not always an option for most people these days), you probably needed to secure a loan before you could finalize the purchase of your property. As a result, you continue to pay your lender a regular monthly amount with the understanding that you will be covering both the principal cost of the loan and the interest the lender charges for their services. Throw in additional costs such as property insurance and taxes, and that monthly payment can get pretty steep.
Refinancing your home gives you the opportunity to secure better interest rates and terms, so you can lower your monthly payments, turn your home’s escrow into cash in hand or pay off your mortgage sooner. While refinancing can be a major advantage in many circumstances, it isn’t always the answer.
Are you asking yourself, “Should I refinance my house?” We can help. Here, we take a closer look at the variables, so you can make the best decision to fit your needs.
What Are Good Reasons for Refinancing?
If you’re not satisfied with your current mortgage, or you feel like you could do better, then refinancing may be the answer. When you refinance, you’re essentially trading in your previous loan for a new one — and then using your new loan to pay off the old one. What are the advantages of switching out one mortgage for another? Well, that all depends. There are several good reasons for wanting to refinance your home, including the following:
Capturing Lower Interest Rates
Probably the most common reason for a homeowner to want to refinance is to secure a mortgage at lower interest rates. Additional taxes and insurance costs aside, your mortgage is made up of two primary components: the principal and the interest. The principal is the amount that you originally borrowed from the lender.. "However, that doesn't mean you're in the clear once you pay back the full amount of money you received. The interest, which is similar to a service charge you pay the bank for lending you money, must be paid as well."
Interest is determined by a number of factors: the state of the economy and other economic indicators, as well as more personal elements such as credit score, type of property and the loan-to-value (LTV) ratio."Because any of these factors may change over time, savvy homeowners who keep an eye out for the right conditions can apply for a new loan at lower interest rates, and then use that loan to close out the previous loan. Done correctly, this can mean a significantly lower amount overall that you have to pay towards your mortgage.
Shortening Your Loan Term
The sooner you can pay off your mortgage, the sooner you can start building personal wealth. Debt can get in the way of your freedom to use your money to achieve your dreams, and without the demands of loan payments hanging over your head, you’ll likely find that your paycheck, savings and investments go a lot further.
Refinancing may be an effective way to shorten the term of your loan, allowing you to pay back your lender more quickly. In these cases, homeowners will refinance for a lower interest rate but then keep their monthly payments more or less the same. This allows them to repay the loan in a shorter amount of time.
Changing Your Mortgage Type
Adjustable-rate mortgages (ARM) offer lower initial interest rates for a predetermined introductory period (usually 5–10 years). Once that period ends, however, the rates periodically adjust to more accurately reflect the market conditions. While ARMs might make sense for those who want to build equity faster or are planning on moving before the introductory term ends, many ARM holders choose to refinance to a fixed mortgage rather than deal with the uncertainty of variable rates and the risk of having to pay more than they can afford once the rates start to jump.
An advantage of switching to a fixed-rate loan is that it locks in interest rates for the duration of the mortgage. For example, a 30-year fixed mortgage at 3% would remain at 3% throughout the life of the loan. Compared to an ARM, fixed-rate loans offer stability and (often) lower overall costs. On the other hand, if trends suggest that interest rates are going to see a continued downturn, or if a homeowner intends to relocate in a short period of time, they may wish to refinance from a fixed-rate loan to an ARM. In either case, refinancing gives them the freedom to change their loan type to match their needs.
Accessing Home Equity Funds
With enough equity in your home, refinancing can allow you to tap that equity and turn it into cash. A cash-out refinance allows you to replace your current loan with a new, larger mortgage, netting you the difference between the amount borrowed and what you still owe.
So, if your home is currently valued at $300,000 and you have a mortgage balance of $200,000, your home equity is $100,000. You could then refinance that remaining balance of $200,000 at $250,000, taking the additional $50,000 as cash. This may make sense if you want to consolidate your debt or need a large amount of money quickly to cover expenses such as medical costs or home improvements.
What Are the Risks of Refinancing?
Refinancing your home can seem very appealing. When the housing market is strong and mortgage rates are low, there are certainly many reasons to want to trade up on your loan. Still, as with any decision involving your finances, you should be aware of the risks before you sign any agreements:
Refinancing at the Wrong Time
Although professional services can reduce some of the hassle, there is still a lot of time, effort and money that goes into refinancing a home. If you haven’t been in your home long enough to build good equity, or if the market or your current financial situation isn’t at a spot where you’ll be able to secure substantially better rates, then refinancing may not be the way to go. Additionally, if your debt-to-income (DTI) ratio is higher than it was during your initial financing, you may risk not qualifying for the new loan.
Extending the Amortization Process
Many homeowners approach refinancing as a way to shorten their loan terms, but be aware that taking out a new loan can actually extend the mortgage by restarting the amortization process. For this reason, many homeowners will choose shorter-term loans when they refinance, so they don’t get locked into another 30-year mortgage on top of the time they may have already invested into their previous mortgage. Depending on your situation it could make sense to extend the loan term as well.
Refinancing with Poor Credit
If your credit score has substantially improved since you originally financed your home, refinancing can mean better rates. On the flip side of that coin, if your credit has taken a hit, you might be looking at unfavorable rates regardless of what the market is doing. Keeping your DTI lower than 30% and maintaining a FICO credit score of at least 670 will help ensure that your personal credit doesn’t get in your way.
Forgetting about Additional Costs
How many times can you refinance your home? There’s usually no set limit (though limitations may vary from state to state). Just remember that with every new mortgage, you’re going to be looking at new closing costs. These costs can include fees for appraisals, attorneys, title insurance and more, and typically range from 2% to 6% of your loan amount. If you don’t take these additional costs into account, or if you refinance your home every time a lower rate presents itself, you might discover that the money you spend on refinancing is more than the amount you save.
When Is the Best Time to Refinance a Mortgage?
Financial experts will offer different benchmarks for determining when to refinance; some say you should wait until interest rates fall at least 1% below your current loan rate, while others recommend refinancing when rates are 0.5% below your current rate. But the truth is, there is no perfect rule of thumb for determining when to refinance your home. Instead, you need to consider all relevant variables and compare them to your current and future needs. Once you’ve run the numbers, you’ll have the insights you need to decide whether refinancing makes sense for you.
Want some help? Pennymac has you covered. We maintain daily updates on US mortgage rates (both for initial purchase and refinancing) and our Mortgage Calculator can do the math for you when you think it might be time to refinance. And, as always, we have mortgage experts standing by to provide guidance, answer your questions, and help you find the solution that’s right for you. Contact a dedicated PennyMac Loan Officer today, and get ready to make your mortgage start working for you.