If you’ve never refinanced your mortgage before, it can feel like a steep learning curve. How do you know which refinancing option is right for you?
Refinancing simply means you take an existing mortgage and replace it with a new mortgage for the same property. You aren’t moving, just changing the terms of your loan while you continue living in your home.
Refinancing makes sense when you want to reduce your interest rate, get rid of private mortgage insurance, lower your monthly payments, or extend your term. Let’s take a look at some common refinancing options and when you might consider them.
The rate refinance is one of the most straightforward refinancing options. In this refinance, you take your old loan and swap it out for a new loan with a lower interest rate. By lowering the interest rate, you’ll save on your monthly mortgage payments and pay less interest over the course of the loan. Ultimately, this refinance is done to save money in both the short and long term.
Consider a rate refinance if interest rates have gone down significantly since you closed on your existing mortgage. You want the savings to be enough to offset the closing costs associated with the new mortgage. Most experts agree that if you can save at least 1% (better if it’s at least 2%) on your interest rate, it makes sense to refinance.
While all refinances adjust the terms of your loan, a term refinance is done specifically to change how long it will take to repay the loan. When you do a term refinance, you are trying to achieve one of two things: extend the loan length or shorten it.
You might want to extend the loan length if you can dramatically reduce your monthly payments by taking longer to pay the loan. Conversely, if you are trying to pay off a mortgage faster, you can often get a better rate for changing from a 30-year to a 15-year mortgage.
Consider a term refinance that lengthens the loan only if absolutely necessary. You’ll be adding closing costs to the loan (or paying them out of pocket), making refinancing potentially expensive. This might be a good option if your income has decreased and is expected to stay that way for a while. It’s better to extend the term of the mortgage than be overextended on your monthly payments.
Consider a term refinance that shortens your loan if you are looking to pay more each month to pay off your home sooner. By converting from a 30-year to a 15-year mortgage, you’ll pay more each month and potentially pay off the loan faster.
FHA loan refinance
There are two FHA mortgage refinance meanings. The first option takes an FHA loan – a loan backed by the Federal Housing Authority – and rolls it along with the associated loan fees into a new FHA loan. This is no different than any other mortgage refinance.
The other option is a PMI-canceling refinance. This type of FHA loan refinance allows you to take an FHA mortgage that has enough equity in the property and refinance it into a conventional loan to get rid of the costly private mortgage insurance (PMI). PMI can be as much as 2% of the original loan amount per year, so it’s pretty expensive to have tacked on to your payments. FHA loans that don’t have at least 20% equity in the property are required to pay PMI to insure the loan against default.
Consider an FHA loan refinance to cancel out PMI as soon as it’s feasible to do so. This means you need to have been in the home for at least two years and built up enough equity (by payment or appreciation) to meet lender requirements. Be sure to talk to your lender to see if there are other guidelines you must meet to be eligible for an FHA refinance.
A cash-out refinance takes an existing mortgage and refinances it while adding into the new loan some of the equity built up in the home. For example, if your home was valued at $350,000 and you had a $200,000 mortgage, you could do a cash-out refinance of $280,000 and take $80,000 in cash when the loan closes to use for a variety of reasons.
Folks often do a cash-out refinance to get funds to update, remodel, or renovate their homes. They can also use it to pay for kids’ college education or to consolidate other debts. Many people consolidate expensive credit card debt into their mortgage through a cash-out refinance, paying off the credit cards to then make higher monthly mortgage payments at a better rate.
Consider a cash-out refinance if you don’t have another way to fund your need. Remember that you’re adding that extra cash to a 15- or 30-year mortgage, so you’ll be paying interest on it for years to come. When consolidating debt, make sure you change your spending habits so you don’t rack up more unsecured debt and risk foreclosure on your home.
We’ve talked about making sure you can afford the closing costs associated with a refinance. Most every refinance has them and you either pay them out of pocket or have the costs rolled into your loan. But there is a refinance that doesn’t charge any closing costs: the no-closing-cost refinance.
This type of refinance sounds great when you consider closing costs maybe $10,000 or more. But keep in mind that nothing is free. Your lender will make up for the lack of closing costs by charging a higher interest rate. If closing costs are added to the loan term, some lenders may refer to it as a no-closing-cost refinance because the borrower doesn’t need to pay the costs out of pocket at the close. Either way, lenders will find a way to get their money.
Consider a no-closing-cost refinance if you don’t have the funds to pay for closing costs and if the loan will save you money in the long run. Be sure to ask the lender what your break-even point is – that is, how long it takes to recoup the refinance costs through what you save each month by refinancing.
A home equity line of credit (HELOC) is a mortgage product that uses the equity in your home to give you a credit line. It’s a loan in addition to your mortgage, and its balance can fluctuate as you pay it off and use it again for anything from home repairs to a dream vacation. A HELOC refinance is when you combine the HELOC with your mortgage into a 15-year or 30-year mortgage with one payment.
Consider a HELOC refinance if you have a large HELOC balance that you can’t seem to pay down. HELOCs usually have higher interest rates than your primary mortgage so combining them and extending the term can help you pay the debt off. While most homeowners prefer the flexibility of the HELOC, if the interest is higher and you can’t pay it off, you might be better off refinancing it all into one, less expensive loan.
A reverse mortgage is a type of loan that allows you to convert the equity in your home into an ongoing revenue stream. Reverse mortgages are typically only available for homeowners 62 and older and supplement retirement income while allowing homeowners to stay in their homes until they die.
You don’t have to make payments on a reverse mortgage. Instead, when you sell your home or pass away, you (or your heirs) either pay off the loan or cede ownership of the home to the reverse mortgage company.
To learn more about which mortgage refinance option may be best for you, check out our article on the factors that affect mortgage affordability.