This post may contain affiliate links. Please read my disclosure for more info.
For most people, their home mortgage is by far the biggest expense each month and will end up being their biggest asset. Considering this, it should come as no surprise that when interest rates start dipping (especially when they’re at all time lows), people start looking into refinancing their home mortgage.
Although there can be many benefits to refinancing your home mortgage, it’s important to understand when to, why you should (and reasons you shouldn’t), and how to refinance your home mortgage.
Table of Contents
What is Home Mortgage Refinancing?
Refinancing is the process of obtaining a new mortgage to take cash out of your home for large purchases (or other reasons), change mortgage companies, reduce monthly payments, lower your interest rate, and/or reduce overall interest paid over the life of the mortgage.
Types of Home Mortgage Refinancing
For the most part, there are two distinct types of home mortgage refinancing. One is to obtain a new home mortgage that is larger than the last in order to pull out equity (and potentially more) in the form of cash. The other is refinancing to get a different rate or term.
Cash Out Refinancing
Cash out refinancing is typically used to pull out cash to pay off other debt, renovations that create equity in the home, or even just to have cash available. In most circumstances, this type of refinancing is counterproductive to getting out of debt and creating wealth as you’re essentially borrowing from your biggest asset to either pay down other debt or fund your lifestyle.
Your home mortgage is secured debt which means your home acts as collateral. If you can’t make your mortgage payments, you could lose your home.
Also, when you borrow from your home, and use the cash on something that is either not an asset or is a depreciating asset, you are decreasing your wealth. When you do this, you are delaying the achievement of your financial goals.
Unless you need the money to live (food, heat, etc.), you shouldn’t consider this type of refinancing an option.
Rate and Term Refinancing
Rate and term refinancing is by far the most common and beneficial. In this situation, you are typically refinancing a better interest rate, similar or better terms (i.e. 30 vs a 20/15 year loan), and/or a better monthly payment.
For the remainder of the article, I’ll be talking specifically about rate and term refinancing.
Why Should you Refinance your Home Mortgage?
Before you dive head first into refinancing your mortgage, you first need to consider the reason why you are considering a home mortgage refinance. As discussed above, the most common type of home mortgage refinance is a rate and term refinance.
People typically do this for the following reasons (one or both):
- To reduce your monthly mortgage payment
- To save on the overall interest paid during the course of the mortgage
The most beneficial to your finances is to find an option that does both. However, this shouldn’t keep you from considering refinancing your home mortgage.
If you can afford it, the best option for your long-term finances is often to lower your interest rate and lower the length of the loan (terms). What this means is your monthly mortgage payment will most likely go up (due to the decreased term of the loan; i.e. 30 year versus 15 year), but you will save dramatically in the overall interest paid during the course of the mortgage. Interest that over the long term can be used to invest and build wealth for you.
When Should you Refinance your Home Mortgage?
When determining when you should refinance your home mortgage, you should consider all of the conditions below:
- Ability to Qualify
- Home Equity
- Income
- Credit Score
- More Favorable Interest and Terms
- Avoid the “Perfect” Interest Rate
- Similar or Lower Term
- Break-Even Point
- How Long it Will Take
- How Long you Will be Paying on the Home Mortgage
Ability to Qualify
Before you start getting excited about the prospect of refinancing, you need to make sure you can qualify. For most refinancing options, you’ll need a certain amount of equity in the home (typically at least 5%), a high enough income to handle the home mortgage payment (see “What Percentage of Income Should go to Housing?”), and a favorable credit score (the higher your score, the better chance of getting approved and landing the lower interest rate).
More Favorable Interest and Terms
In order to get the most out of a home mortgage refinance, the interest and terms should be favorable enough to make it worth the closing costs. Some of the terms you might want to change are the length of the loan, fixed rate versus adjustable rate, the type of loan (FHA versus conventional; get rid of FHA mortgage insurance), etc.
If solely refinancing because of interest rate, I wouldn’t even start looking at refinancing unless the interest rate was 0.5% or more lower than your current interest rate and/or you’re considering a serious deduction in the terms of the loan (i.e. 30 years versus 15 years).
Don’t Chase the Perfect Interest Rate
How do you know when the interest rate has reached it’s low? Well, you don’t. You can do research and follow trends, but ultimately you can’t predict the future. Don’t miss out on a great opportunity for refinancing because you were waiting for the perfect interest rate.
Shop Around
When looking at the interest rates, be sure to shop around with several different lenders included the company that currently holds the mortgage.
Target Similar Loan Lengths Than Your Current Remaining Years
When shopping around, try to look at loan lengths that are similar to or shorter than your current remaining years on the mortgage.
For example, if you had a 30-year mortgage and have been paying on the mortgage for 20 years, you should be looking at 20 years or shorter-term mortgages. If you do more than your current term, you’ll end up paying more in interest in the long-term.
The Break-Even Point Matters
If you think you’ll only be in the home for a short time, make sure to calculate the break-even point for the additional closing costs associated with the refinance. You may decide that it takes too long to recoup the costs and prefer to hold off for the time being.
How Long Will It Take to Break-Even on the Closing Costs?
Now that you know you can qualify and that the interest and terms are favorable, it’s time to check the break-even point on the additional closing costs.
To calculate the break-even point, simply use the formula below:
Break-Even Point = Total Closing Costs/Monthly Savings
The break-even point is reported in months. This is how long you’ll need to own and make payments before the closing costs associated with refinance have been offset by the monthly savings.
For example, let’s say the total closing costs are ~$3,000 (assume prepaids for escrow are not included, but are the same as your current escrow) and your monthly savings are $150/month. To calculate the break-even point, divide the total closing costs by the monthly savings ($3,000/$150 = 20 months).
If you think you’ll own and pay on the mortgage for more than 20 months, then a refinance makes sense.
If you think you’ll sell the home within the next 20 months, you need to reconsider financing as it will cost you more than just sticking with your current mortgage.
Let’s revisit the previous example. For this example, let’s say you’re in the military and have a 36-month assignment. You’ve been in the home for 13 months and it will be ~14 months at the time of the refinance closing if you decide to pursue it. You think you’ll be eligible for another assignment at the same location at the end of this one, but don’t have any guarantees.
If you add the previous 20 months to the 14 months you’ve been in the home, it will be around month 34 before the break-even point. Although you technically will break-even before you’ll be looking to potentially sell it, it’s up to you whether or not the little bit of savings is worth the headache.
How to Refinance Your Home Mortgage
Once you’re ready to refinance your home mortgage, it’s really a simple process.
To start, identify what you’re hoping to accomplish. Are you looking to reduce monthly payments? Shorten the loan term? Reduce the amount of overall interest paid on the loan?
Shop around to find the best mortgage refinance rate. Pay close attention to any fees and the break-even point. If the deal is a better long-term deal, but you’ll most likely sell the property before you can take advantage of it, you should probably consider the better rate that fits within your required break-even point.
Apply with the top lenders (typically 3-5). Just because they quote a certain rate and terms, it doesn’t mean you qualify. Also, make sure to apply with the top lenders within the same 1-2 week period to avoid any dings to your credit.
Choose a mortgage lender. Compare the Loan Estimate document for each of the lenders above and pick the one that best fits your situation.
If you can, lock in your interest rate. Most place will allow you to lock a rate for 30 days with the option of 60 days with an additional fee. Make every effort to close before that rate lock is up.
Finally, prepare for closing which includes making sure all of your documentation is up to date and submitted as well as securing the cash for the closing costs.
What Happens to Escrow When you Refinance?
Typically, you pay for the prepaids (insurance, taxes, etc.) with the new mortgage company (assuming its different from your previous mortgage company) at closing. Then your old mortgage company will send you the balance of your old escrow when they close out your account.
Home Mortgage Refinancing Guide – Conclusion
When looking to refinance your home mortgage, it’s important to consider why your doing it, when is the best time, and how to do it correctly. If done correctly, a home mortgage refinance can help you save thousands over the life of your home loan.
Have you refinanced your home mortgage? If so, why did you do it?