Refinancing has been a hot topic in the headlines since interest rates were historically low (below 3%!) throughout early 2021. Though rates have slowly risen as the year has gone on, they are still low enough to tempt many into considering a refinance. In the right circumstances, refinancing can be beneficial; however, it requires an investment of time, money, and effort, so it’s important to fully consider the pros and cons before moving forward.
- What does “refinancing” mean?
Refinancing a mortgage is when you replace your existing loan with a new one and, ideally, have more beneficial terms (for example, a lower interest rate and monthly payment). There’s no obligation to stay with your current lender so you can feel free to shop around for the best interest rate and client service offered.
- What are the reasons to refinance?
Refinancing is done for a variety of reasons, the most common of which are to obtain a lower interest rate or shorten the term of a mortgage. Reducing your mortgage interest rate can help save you money over the duration of the loan, as well as decrease the amount of your monthly payments and increase the rate at which you build equity. Refinancing to shorten your loan term can allow you to pay off your mortgage faster. Another reason is wanting to use the home equity to raise cash to finance large purchases, like home repairs, consolidate debt (including student loans), or pay for an emergency financial situation. Refinancing can also be done to change the type of mortgage you have, such as switching to a fixed-rate mortgage from an adjustable-rate mortgage (ARM) or vice versa.
A fixed-rate mortgage can be advantageous because you’re locked in and your interest rate won’t change, so you’re protected from any sudden changes to your monthly payments. On the other hand, the variable interest rates of ARMs can be beneficial; the rate usually starts out lower than a fixed-rate loan and rises over time. If you’re not planning to stay in your home for more than a few years or are in an environment where interest rates are declining, an ARM can be the best way to go.
- How do I refinance? Do I meet the requirements?
Although refinancing is a process, it’s generally less complicated than when you initially buy a home and get approved for a mortgage. It normally takes 30-45 days and requires updated documentation. Lenders may ask for recent pay stubs, W-2s, 1099s, bank statements, or other income documentation if you’re self-employed; they’ll want these from your spouse and anyone else who will be listed on the mortgage as well.
Requirements for refinancing can include your name being on the home title for at least 6 months to a year, having a decent credit score (the higher the better since it will affect the interest rate you get), your current home equity (20% or more is the general rule), carrying a good debt-to-income ratio, and being able to afford the costs of closing on the new loan.
- When should I refinance?
You should consider a variety of factors if you’re deciding when to refinance. These include current market trends (such as inflation and interest rates) and your personal financial situation (like your credit score, job security, and debt). If you’ve recently taken on additional debt or your credit score took a hit, it may be worth waiting until you pay down the debt and improve your score as these aspects will affect your new mortgage rate. Having enough cash on hand to cover closing costs for the new loan, which is usually between 2-5% of the principal amount of the loan, is also important.
You’ll also want to make sure that refinancing is worth the additional money and time you’ll be investing into the process. You can confirm this by doing the math to see how long it will take to break-even on your refinance. By dividing your closing costs by the monthly savings of your new mortgage, you can see how many months it will be before the savings really kick in.
Refinancing is a big decision, so it’s important to feel confident with the numbers and requirements before moving forward. It’s always a good idea to check in with a professional such as a CERTIFIED FINANCIAL PLANNER™ or CPA when determining if it’s the right time and circumstances for you to engage in a refinance. They can help you consider how it could affect your savings, financial outlook, taxes, future plans, and more.