Whether it's to take advantage of low-interest rates, to alter the length of the loan, access equity, or consolidate debt, the question of when to refinance a mortgage is one that looms large for every homeowner. There is no definitive answer – it depends on your individual circumstances and financial choices – but there are certain times when it can be advantageous to refinance.
What is mortgage refinancing and how does it work?
Mortgage refinancing is the process of replacing your current home loan with a new one. This loan is partly used to pay off your old mortgage and will have a new interest rate.
There are several steps to follow when refinancing a mortgage. Though these steps can vary depending on the lender and your financial circumstances they tend to align with the following roadmap.
1. Choose how you want to refinance your mortgage.
The first thing to do when refinancing a mortgage is to settle on exactly what type of mortgage refinancing to go for. There are several types of mortgage refinance including:
- Rate and term refinance - The most common type of refinance, this involves changing the terms of your current mortgage including interest rate and the length of the payback window.
- Cash-out refinance - Getting a loan amount larger than what you need for the mortgage, cash-out refinancing results in an excess of funds that can be used for other purposes.
- Cash-in refinance - The opposite of a cash-out refinance, cash-in refinance allows the borrower to contribute a lump sum to the lender to decrease the overall amount owed later on.
- No-closing cost refinance - Instead of paying closing costs in one go at the end of the application process these costs are absorbed into the loan itself.
2. Find a lender
Now it's time to choose a lender. Every lender will offer unique terms when it comes to how the loan is structured. It is important to research and compare them thoroughly so you can find the one that offers the best deal for your situation.
3. Gather the relevant documents
Like most financial transactions of a large scale, the process of refinancing a mortgage can be rather complex. It is important therefore that you have all the necessary paperwork on your end prepared. This may include the following:
- Wage Statements (W-2s)
- Tax returns
- Pay stubs
- Statements of debts and assets
4. Fix your interest rate
Once your loan has been approved you can either choose to lock your interest rate or float it. Locking your interest rate protects against any potential interest hikes while floating it does the opposite meaning that you could end up with a lower interest rate if they decrease but could equally result in higher payment if rates increase.
5. The underwriting process
It’s now up to the lender to review the financial information you have provided along with your credit history to make sure everything is accurate and in order! They will also conduct a home appraisal to determine the property value.
6. Closing the deal
If all goes well it's now time to close the deal. Your lender will send you a closing document that outlines the terms of your new mortgage. After the paperwork is signed and the closing costs are paid your new loan will be made active and it's time to start paying it back according to the new terms.
When can I refinance my house?
Technically, you can refinance a house just six months after your original purchase, although this is not advisable for most people due to closing costs and the likelihood that interest rates will not have changed to a significantly beneficial degree. There are several factors, both personal and related to the wider economy, that influence when you might consider refinancing.
When should I refinance my house?
One of the best times to refinance your house is when interest rates are low. Low interest rates on their own are not necessarily advantageous enough to warrant a home refinancing. Other factors such as the length and type of mortgage and any changes to the parties involved are also factors that must be considered.
Interest rates are low
If mortgage refinance rates have dropped by 0.5% or more, it could be a good time to refinance. The benefits of this are simple: If you take a loan with a lower interest rate, your money will go further to paying off the money you have borrowed.
For example, you may have taken out an initial loan during a time of economic uncertainty, when interest rates were at 7%. Put simply, this means that for every $10,000 you borrow, you pay back $10,700.
Fast forward a few years, and let's say interest rates have dropped to 4%. However, the decrease doesn't affect your initial loan taken at 7%. You'd still owe $10,700 on the original $10,000 loan unless you refinance. But any new loan taken at this lower rate would be cheaper, costing only $10,400 to repay after one year.
A drop in interest rates presents a good opportunity for refinancing, with the potential for significant savings on a monthly basis, depending on the length of your loan and the amount you borrowed.
To shorten your mortgage term
It’s possible that in the time since taking out your initial home loan, your financial situation has improved. Maybe you’ve had a pay rise or inherited a large amount of capital, for example. If this is the case and you can afford to pay more each month, you may be able to shorten your mortgage term and therefore be mortgage-free sooner.
To lengthen your mortgage term
If you have encountered financial difficulties since your initial mortgage loan was taken out, you can spread the cost of paying back over a longer period.
For example, before refinancing you may have been paying $1,000 a month on a 20-year agreement. After refinancing that cost can be spread much longer to 30 years at a lower cost of only $700 a month.
This can be a great option if you're struggling with monthly payments that are too high. However, in most cases, a longer mortgage term means you will be paying back more interest over time.
Your credit score has improved
If your credit score has improved since your initial mortgage loan, you may qualify for a loan with better terms – namely a lower interest rate. Chances are that if you have been paying your previous mortgage term every month and on time then your credit score may have improved without you even realizing it.
To switch from an ARM to a fixed-term mortgage
The interest rate on an adjustable-rate mortgages (ARM) fluctuates in real time, as interest rates change in the wider economy. An ARM can be beneficial because it means that the amount you pay back is lower when the Federal Reserve lowers the national interest rates. However, it also means you pay more when they hike the rates.
The difficulty in accurately predicting future interest rates can make switching to a fixed-term mortgage attractive for those considering refinancing.
Fixed-rate mortgages, as the name suggests, are mortgages with an interest rate that is fixed for a set time, normally between 15 and 30 years. Not only do fixed-rate mortgages ensure that you know exactly how much you will be paying back each month, but they can also protect you from outside influences on the economy.
To consolidate debt
If you have a lot of high-interest debt, such as credit cards, and you want to make your payments more manageable, using money from a cash-out refinance could be an option to pay off those debts. The interest rate on a mortgage loan is typically far less than the interest rate on a credit card, so it could be advantageous.
To switch from a fixed-term mortgage to an ARM
Alternatively, your current mortgage may be fixed term and you wish to take a chance with an ARM. This could be beneficial if your refinancing period happens during a time of high interest rates that are likely to go down in the short-medium term future.
To add or remove a borrower
It is not uncommon for people to refinance their mortgage to remove a borrower from the agreement – for example, due to a divorce. Similarly, you may wish to add a borrower to the agreement.
Adding or removing a borrower can also have an effect on the interest rate and terms offered. For example, if the person who you are removing has a much stronger credit score than you then you may be forced to pay higher interest rates. Similarly, if they had a poor credit score in comparison to yours then taking them out of the equation could open up loans with better terms for you.
Note that refinancing is not necessarily required if one of the borrowers passes away.
To convert home equity into cash
When refinancing your mortgage, it's possible to borrow more money than you actually need to finish paying for your home. The difference is paid to you in cash. This can be an attractive option for people who need access to a lump sum for college, vacations, renovations, etc.
The cash-out option may mean that you will pay back more in the long term. Lenders will need to be confident in your financial stability before agreeing to this option.
When should you avoid refinancing your mortgage?
Most people choose to avoid refinancing when interest rates are high. This is because you do be locked into this high rate, if you choose a fixed-rate mortgage. Similarly, if you choose an ARM in the hopes that you’ll benefit as rates drop – it is also possible for rates to rise even further, putting you in a difficult financial position.
Refinancing may also not be worth it if the closing costs outweigh any potential financial benefits. Closing costs are fees associated with refinancing, such as attorney or application fees.
The time it takes to recoup these closing costs with your new savings is known as the break-even period. Every break-even period is different, and it is a personal decision as to when a break-even period becomes too long to be worth the refinancing.
If you have struggled with financial payments and have suffered damage to your credit score, your loan options may be limited. This means that your refinancing options may all have interest rates that are too high to make refinancing worthwhile.
Finally, if you don't have enough equity built up you may be ineligible to refinance. This is most likely to be the case if you are a recent buyer and haven’t had the time to pay much back to your lender or if your down payment was below 10%.
Should I refinance my mortgage?
Knowing when or even whether you should refinance your mortgage is not an easy task. It’s highly subjective and there are many aspects to consider, such as interest rates, break-even periods, ARM vs fixed-rate mortgages, the type of refinance to choose, and the length of your loan. If you are considering refinancing your mortgage in Indiana, Michigan, Illinois, or Ohio, connect with a First Merchants mortgage banker for help. They can review different options including potential costs or savings to help you make an informed decision.
However, there are some consistent rules that apply in most cases:
- Refinance when interest rates are low
- Refinance when your credit score is in a good place to secure the best deals possible
- Refinance if it is financially advantageous to alter the length of your loan
Keep in mind that the cost of refinancing your mortgage will vary depending on interest rates, credit scores, closing costs, the length and terms of the loan, and many other factors. Use our mortgage refinance calculator or speak with a mortgage professional to learn more about your personal position and how much refinancing could cost you.
