Is Now A Good Time to Refinance Your Mortgage?

The Coronavirus pandemic has had significant economic impacts. One of these is that interest rates have fallen greatly. You may have noticed this and are probably wondering if you should refinance your mortgage. There are many advantages to refinancing, but since everyone’s situation is different, you should evaluate whether it’s the right thing for you to do.

WHAT IS REFINANCING?

When you refinance you are essentially swapping loans. You take out a new loan, using the money from that loan to pay off the older loan. There are a few reasons to do this. One is to get a lower interest rate. Another would be to change your existing mortgage to one with a shorter term with the goal of paying off the mortgage sooner. And yet another reason is to take money out of the equity to use for other purposes, such as remodeling or perhaps medical emergency expenses. This is frequently done through a HELOC or home equity line of credit, but can be done at the time of a mortgage refinance as well.

For example, if you currently have a 30-year fixed mortgage with a 4.25% interest rate on it, you might want to refinance to a new 30-year mortgage with a 3% interest rate. That would result in a lower monthly payment than the existing mortgage.

However, if you refinance a 30-year mortgage to a 15-year loan, your monthly payments may actually go up, even if the rate on your new mortgage is lower. You’ll still save money in interest over the life of the mortgage because you’ll pay it off sooner.

WHEN TO REFINANCE

Generally, if the goal is to lower the monthly payment, refinancing isn’t worthwhile unless the new interest rate isn’t at least 0.50% lower than the existing interest rate. A better rule of thumb though is for it to be 0.75% to 1.0% lower than the interest rate of the existing loan. This is because the reduced interest rate needs to compensate for the closing costs associated with the refinance. If the change in interest rates is smaller, then the amount you save each month with the mortgage payment is offset by whatever was spent on the closing costs. This leads to a discussion about loan terms and breaking even on those closing costs.

LOAN TERMS

Most people thinking of a mortgage think of a standard 30-year term. However, homeowners shouldn’t necessarily default to a 30-year term for their mortgage. Rates have fallen so much, you could possibly get a 15-year loan while maintaining your current monthly payment amount. It may even be possible to get into a 15-year term and still end up with a lower monthly payment. That all depends on what the interest rate and other terms of your current loan is, especially if you have a first and a second mortgage or a HELOC you’d like to payoff and work into a lower interest rate mortgage.

Most likely, if you wanted a 15-year term you will pay more monthly. This is where you need to look at how soon you want to payoff your mortgage, as well as how much less you’ll spend overall in purchasing you home.

For example, if five years ago you bought a house with a $500,000 loan at a 4.50% interest rate your monthly payment is $2,533. If you kept your mortgage the way it is, by the time you payoff the mortgage in 25 more years you will have paid $912,034 total for your home (plus any downpayment and closing costs of the original mortgage).

Now, let’s look at a couple refinance options. It’s important to note that if you started with a $500,000 loan at a 4.5% interest rate, after five years you would have spent about $152,000 and would have a remaining principle of approximately $455,000. Say you find a 30-year refinance loan right now with a 3% interest rate. With a remaining principle balance of $455,000 that would give you a new monthly payment of $1,918, and you will have spent an additional $690,587 to purchase the home by the end of that new 30 year term. That’s $842,587 total. By extending your mortgage another 5 years (the 5 years of your initial mortgage, plus the 30 year refinance) you saved $69,447 in interest.

Now, let’s look at a 15-year refinance. With a 2.5% interest rate, and $455,000 starting principle, you’d have a new monthly payment of $3,034. By the end of the 15 year term you’d pay an additional $546,100 to purchase the home, bringing the total to approximately $698,000. That’s a savings of $214,034 in interest payments, plus you’ve paid your home off in only 20 years instead of 30 or 35 years.

Obviously the benefit of a 15-year term over 30-year term is there. A shorter term has trade-offs though. Locking yourself into such a loan with a higher payment gives you less flexibility in your spending budget. A standard 30-year mortgage offers flexibility. One way around that trade-off is to make extra principle payments when you have extra cash and feel comfortable spending it. There’s nothing forcing you to make those additional principle payments though, so it requires discipline.

Some lenders do allow you to switch to automatic bi-weekly payments. Bi-weekly payments are payments every 2 weeks that are half the monthly mortgage payment. This essentially has you making one extra monthly payment per year. Typically you can expect bi-weekly payments to knock off as much as 5 years off a 30-year mortgage and may be a good option for those who don’t want to be forced into higher monthly payments, but want a systematic way to payoff their mortgage sooner.

CHECK WHEN YOU’LL BREAK EVEN

Another factor on whether or not to refinance concerns how the closing costs affect the overall cost and what it means when compared to the change in the monthly mortgage payment. Closing costs are administrative fees, loan origination fees, title fees, and other fees the lender and others involved with the loan charge. Closing costs vary by lender and could range from zero to thousands of dollars.

If the closing costs are $8,000, and refinancing lowers your monthly mortgage payment by $200 per month, it would take 40 months just to break even and offset the closing costs. If you have no plans to move in the next three years and 4 months then refinancing might make sense. However, if you’re only planning to stay in your current home another year or two, then it’s probably not worth it because you’ll actually be spending more on closing costs than you’d be saving on your mortgage payment over that couple of years.

The important thing to remember is that it only makes financial sense to refinance if you’ll own the home long enough to recover the closing costs.

SHOULD YOU TAKE CASH OUT?

When refinancing you might be able to take cash out of the equity of your home. When you take cash out during refinancing you are actually borrowing more than you owe on your existing mortgage. Usually you’re limited to borrowing no more than 75 to 80 percent of the appraised value of your property, but this does depend on the type of loan and other factors such as credit history, income, and other existing debt.

Cash-out refinancing has certain advantages. The interest rate that you pay on the mortgage will usually be less than the interest rate on other debts you may be looking to payoff such as car loans, personal loans, credit cards, and even some student loans. There are also disadvantages to cash-out refinancing. One of the biggest disadvantages is that your refinanced mortgage is secured by a lien on your home. As a result, if you can’t make the mortgage payments, the lender can foreclose on your home and sell it to pay the mortgage. Usually having your home repossessed is worse than having your car repossessed if you come into hard times financially and are unable to make some of your payments.

TAX ADVANTAGES

Sometimes to get a lower interest rate you need to pay points. If the points paid are an up-front charge for interest in return for a lower interest rate, then the money paid for those points is tax deductible. However, with a refinance, many times those points are added to the loan principle and not paid out-of-pocket. In that case the points are deductible over the life of the loan instead of the year in which the refinance closed. If you later refinance again or sell the home, you typically can claim the entire remaining unamortized deduction.

QUALIFYING

One might think that if you’ve been paying your existing mortgage for several years, and potentially with a higher payment than what the new payment will be, that approval for the refinance would be automatic. That isn’t the case though. Just like with your original mortgage, you need to apply and be approved for a refinancing loan. Whether or not you’re approved, the amount you’re approved for, the length of the loan, and the interest rate are all tied to various factors. As mentioned above, these factors include your credit score, income, other existing debt, and how long you’ve worked in your current job to name a few.

Millions of Americans have lost their jobs or were furloughed because of the pandemic, so it may be more difficult than usual to get approved for a loan. The standards that lenders require borrowers meet to qualify for a new loan have been raised, including higher credit scores, lower debt-to-income ratios, longer employment history, and other criteria.

If you were laid off, furloughed, or even if you’re self-employed, it may be more difficult to be approved for a loan right now. If you’re in one of those situations, and you’re finding that you can’t get approved for a refinancing loan, you could try your existing lender. If you’re in a situation where you need to lower your mortgage payment or risk being unable to make the payment, your lender may be able to offer you better terms. There are relief options available to lenders in these situations, so it wouldn’t hurt to make the phone call.

The CARES Act made it possible to claim forbearance from their mortgage payments. This is a relief option available that allows you to halt your mortgage payments if you are experiencing a loss of income due to pandemic-related circumstances. However, taking advantage of forbearance could disqualify a homeowner from certain types of loans. If you requested forbearance, but continued making payments, you’ll be eligible to refinance as long as you stay current on your loan payments. However, if you skipped payments while in forbearance, before applying for a refinance loan you must begin making payments again. After making at least three current payments you may be eligible for a refinance loan backed by Fannie Mae or Freddie Mac.

Because of the extra scrutiny that is being placed by lenders due to the current pandemic economy, it is recommended to do the following before you apply:

• Check your credit report at the three credit reporting companies to ensure there are no inaccuracies.
• Don’t do anything that will negatively affect your credit score. This means don’t apply for any credit cards or make any large purchases on credit.
• If you’re self-employed or have income that varies, expect your income to be analyzed closely.
• Have your tax returns for the last two years ready.

THE BOTTOM LINE

As you think about refinancing, consider the length of time you plan to stay in your current home and the costs associated with refinancing. If you’re in the home you plan to retire in and live in for the rest of your life, then refinancing might make sense. If you plan to sell your home within five years or so, it may not be worth it because you could end up paying more in fees than you’d save on the monthly payments.

Ultimately, you need to think about whether refinancing is a smart move for you or not. If you’re unsure if you should refinance and would like an evaluation and review of your options so you can make the best decision for your situation, feel free to...