The Ultimate Guide to Mortgage Refinance
TABLE OF CONTENTS
WHAT IS A MORTGAGE REFINANCE?
A mortgage refinance reduces monthly mortgage payments by replacing an existing mortgage with a new one, with a lower interest rate and shorter term.
The most common type of loan is a 30-year fixed rate mortgage. When borrowers get one, they make a 30-year commitment. That’s a very long time. A lot can change over three decades. Interest rates will undoubtedly change. If interest rates are lower now than when the original mortgage was taken out, borrowers can take advantage of today’s lower rates by refinancing.
A cash-out refinance allows borrowers to extract home equity from their home, as cash. People do this to pay for major repairs or upgrades to a property.
When a borrower and co-borrower part ways (get a divorce), refinancing provides a way to split up their assets.
To borrow a tactical phrase from the military: conditions on the ground change. And when the conditions are right for it, a mortgage refinance is in order.
Closing costs are a fact of life for every home loan transaction, including mortgage refinances. They impact the total cost of a refinance. So the “all in” cost should be calculated to understand the actual long-term savings. If you don’t want to pay closing costs out of pocket, your lender can cover them. This is call a no closing cost or zero closing cost refinance. Here’s how it works: your lender pays the closing costs and then recoups them over time by charging a higher interest rate.
The breakeven point indicates how long it takes borrowers to recoup mortgage refinancing closing costs.
For example, if closing costs on a mortgage refinance are $6,000 and the expected monthly savings is $300, it will take 20 months to break even ($6000 ÷ $300 = 20). Given the breakeven point is nearly two years out, refinancing probably doesn’t make sense if the borrowers plan to move or buy a new home soon. Know what I mean?
Your loan advisor can help you run the numbers.
Reasons to Refinance a Mortgage
There are two major mortgage refinance options, Rate & Term and Cash-Out refinances. Nearly every reason a borrower may want to refinance will be covered by either of these choices.
RATE & TERM MORTGAGE REFINANCE
A Rate and Term refinance lowers your monthly mortgage payment. It’s a simple as that. Here some reasons to consider this option.
1. Lower Monthly Payment
There are two major levers to pull that reduce a mortgage’s monthly payment, its rate or term.
A lower interest rate reduces the cost of borrowed money. Thus the interest portion of a monthly mortgage payment is smaller. As a rule of thumb, borrowers will have an incentive to refinance when the interest rate on their mortgage is 75 basis points higher than the prevailing rate. One percent of interest is the same as 100 basis points. For example, 5.75% is 75 basis points higher than 5.00%.
A longer mortgage term reduces monthly payments by spreading them out over time. For example, if a borrower has been making payments for 5 years on a 30-year mortgage, they still have 25 years left to pay off the loan. Refinancing the principal balance into a new 30-year mortgage will lower monthly payments. However, that comes at cost. Resetting the amortization period pushes a borrower farther away from owning the home outright.
2. Cancel FHA Mortgage Insurance (MIP)
Upfront Mortgage Insurance Premium (UFMIP) is paid at closing on FHA purchase loans. Then borrowers pay an annual Mortgage Insurance Premium (MIP), made in monthly installments. MIP sticks with the life of an FHA loan until a borrower refinances it into a conventional mortgage.
Note: FHA mortgages made before June 3, 2013, have a provision to make annual MIP go away automatically when a home’s loan-to-value (LTV) reaches 78% on last known value of the home. MIP must be paid for at least 60 months if it’s a 30-year mortgage. There’s no 60-month payment requirement on 15-year FHA mortgages.
3. Pay Off a Mortgage Faster
Above, we talked about increasing a mortgage term to reduce monthly payments. Some borrowers decide to go the other direction and shorten the term to pay off a mortgage sooner.
EXAMPLE 1: A young family with children decides to convert a 30-year mortgage to a 15-year mortgage. They want to be free and clear of house payments by the time their children reach college age. As school teachers, they know their income will be significantly higher in 15 years, too. They plan to pay for their children’s college expenses with their regular income.
Furthermore, they intend to stay in their home forever – no future plans to move. They decide to pay off their 30-year fixed rate mortgage faster by converting it into a 15-year loan. Thus, they will not have house payments when their first child reaches college.
EXAMPLE 2: Another couple is planning their retirement and expect to quit their jobs in 10 years but have 20 years left on a 30-year note. They decide to refinance into a 15-year fixed rate mortgage to accelerate the payoff. They’ll be debt-free when they retire and living on a fixed income becomes a reality.
4. Convert an Adjustable Rate Mortgage (ARM) to a Fixed-Rate Mortgage (FRM)
Converting an ARM to an FRM gets rid of payment uncertainty. If it looks like interest rates will be going up over the next several years, it makes senses to capture a lower rate in the near term.
At the end of a Hybrid ARM’s fixed period (i.e. 3/1, 5/1 and 10/1) the monthly mortgage payment becomes adjustable. At that time, it could make send to refinance into a fixed-rate mortgage. Refinancing this way would lock your monthly payments at an expected amount.
CASH-OUT MORTGAGE REFINANCE
A cash-out refinance allows borrowers to extract built up equity from their home. The proceeds may be used any way the borrower wishes. The original mortgage is replaced with a new one, now with a higher principal balance. That’s because the withdrawn equity is added to the loan principal, minus closing costs.
Refinancing resets the mortgage term. So when borrowers cash-out, they are forestalling the accumulation of equity in their home and increasing the length of time it takes to pay it all off. This could be a setback if the borrower’s goal is to eventually own the home free and clear. Pulling equity out of a home to pay off other debts can be symptomatic of poor financial discipline.
5. Settle a Divorce
Refinancing can be an important tool if one divorcing spouse wants to keep the family home. When dividing up assets, a cash-out refinance can make both parties whole by splitting up the shared equity in the home.
After the refinance, only the spouse keeping the home will be on the new mortgage note and title. The other spouse’s share of the home is bought out with the proceeds from the refinance.
6. Tap into Equity
Home equity can be used as a financial tool for a variety of economic needs. Here are some of the typical reasons borrowers tap into it:
- Savvy investors can leverage equity in their current investment properties to buy more investment properties
- Finance major upgrades to the house and other home improvement projects
- Source of funds for emergencies or other financial setbacks
- Pay college tuition
7. Consolidate Debt
Mortgages typically carry the lowest interest rate of any kind of loan. This is why some borrowers consider a cash-out refinance. The cash proceeds can pay off higher-interest debts like:
- Installment loans
- Revolving debt such as credit cards
- Student loan debt
Let’s be clear; you still owe the money. But consolidating debts into a single mortgage reduces the financial burden on borrowers by:
- Spreading payments over a longer time period
- Lowering the interest rate
- Getting a tax deduction on interest
Cash-outs can even combine first and second liens. Second mortgages generally have higher interest rates. So combining first and second liens into one single mortgage can lower monthly payments.