Even with low interest rates, take a full view of your financial situation before going down the road to refinancing.
The tumultuous impact of coronavirus on the economy has led the Federal Reserve to cut interest rates in order to encourage spending, which has caused record-low mortgage rates.
As a result of the low rates, many homeowners have applied to refinance their mortgages. The Mortgage Bankers Association Weekly Mortgage Applications Survey reported a 106% year over year increase for the week ending June 12, 2020.
“Usually, a good time to refinance is when the rates and terms in the market meet your goals, but most folks start to become interested in refinancing when they can improve their existing loan’s rate by a percentage point or more,” says Keith Gumbinger, vice president of HSH.com, one of the largest publishers of mortgage data and consumer loan information.
Determine the goal of refinancing
When you refinance, you’re basically replacing your existing loan with a new one. Homeowners often pursue refinancing to build extra liquidity or reduce long-term interest payments.
A cash-out refinance can give you access to home equity you’ve built over the years. This is usually an option for those who have lived in their home for at least 7 to 10 years, says Natalie Colley, an associate advisor at Francis Financial and certified financial planner.
When you refinance your current mortgage, you have the option to lower monthly payments if you can secure a lower interest rate. You can also shorten the loan term from a 30-year mortgage to a 15-year mortgage, or the reverse, which can lower your monthly payments, but increases the interest payments over time. Consumers can also switch from an adjustable-rate mortgage to a fixed-rate mortgage, which can prevent a spike in interest rates from increasing your monthly payments.
“Those with extra cash flow to pay a higher monthly payment are in the best position to take advantage of significantly reduced interest rates,” Colley says.
Whether or not you decide to pursue a mortgage refinance will often hinge on how long you plan to live in your home, interest rates, your financial situation, and closing costs.
How credit scores and personal finances impact refinancing
When you apply for mortgage refinancing, lenders consider your credit score, debt-to-income ratio, and employment.
“If you have had an interruption in your employment history, you might have difficulty getting a new loan,” Gumbinger says.
A loss of income will impact your debt-to-income ratio, which lenders use to determine your ability to make monthly mortgage payments. Lenders are usually more cautious to lend to someone with a higher debt-to-income ratio.
Another key factor lenders review is your credit score. Review your credit report to remove any erroneous information that may be negatively impacting your score. If your credit score has improved since you bought your home, it may be worth it to refinance, says Joanne Gaskin, vice president of scores and analytics at FICO.
“Lenders and investors rely on the FICO score to help predict the likelihood that a consumer will repay the loan, and it’s also used to help inform the interest rate on the mortgage,” Gaskin says.
Gaskin uses the following example of how a consumer could potentially save money by refinancing:
Let’s say you had a FICO score in the 660-679 range when you originated the loan. You’ve since improved your score to the 700-759 range. You could potentially save $21,474 over the life of a $275,000 home loan.
If your credit score hasn’t improved since the lender issued your loan, but interest rates have dropped, there could still be an opportunity to reduce your monthly payments or the term of the loan.
“The general rule of thumb is that if you can reduce your interest rate by 1 to 2 percentage points, it’s worth doing a bit more research to understand the cost-benefit tradeoff,” Gaskin says.
Consider refinancing costs
If you’re interested in refinancing, review the closing costs associated with mortgage refinancing to determine if you’ll actually be saving money.
To better understand the costs, you can ask your lender to list out all of the closing costs, which can include fees for a title search, home appraisal, loan origination, application, and more. The loan origination fee is usually 1% of the mortgage balance. A new appraisal, title search, and application fee can cost several hundred dollars each.
Loan fees can be paid out-of-pocket or incorporated into the loan amount. Another option is a no-cost refinance, which can eliminate upfront costs, but result in higher monthly payments, Gumbinger says.
If you plan on selling your home in a couple of years, refinancing may not be beneficial, as it usually takes time to pay off closing costs, i
“To calculate how many months it will take to recoup the closing costs, and begin saving money on the new mortgage, divide the closing costs and associated feeds by the difference in mortgage payments between the old and new mortgages to find the break-even point,” Colley says.
Shop around and compare refinancing rates
Factors such as your credit score, down payment, the length of the loan, and the mortgage amount can all impact the refinancing process. It’s best to shop around to find the best rates.
“It’s really crucial to shop around,” Colley says. “Reach out to your lender, but don’t just look at your own bank.”
Natalie Colley is an associate advisor at Francis Financial. She is a certified financial planner as well as a certified divorce financial analyst. She has been featured in various press outlets such as CNBC, Kiplinger, MarketWatch, Financial Planning, Daily Finance, Grow from Acorns, Mass Mutual, Real Simple Magazine, and U.S. News & World Report. Natalie volunteers for the Financial Planning Association and has led financial fitness workshops for the Financial Planning Association of New York. She also hosts money conversation circles with various groups of women to encourage open communication about personal finance.
Joanne Gaskin is the vice president of scores and analytics at FICO. She is responsible for the strategic direction of FICO’s scoring products and business partnerships serving the needs of the mortgage industry and led the FICO Mortgage Recovery Initiative launched in 2009. Gaskin has more than 20 years of experience in banking and financial services. She led efforts to address some of the most important topics impacting the mortgage market today: regulatory compliance, credit risk management, data security and e-mortgages. She is a graduate of the Mortgage School of Banking, earning the Accredited Mortgage Professional Designation.
Keith Gumbinger is vice president of HSH.com, a mortgage information website and is a mortgage expert and analyst with more than 35 years tracking the mortgage industry for consumers.
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