As homeowners, we are often pressured to refinance our mortgage. We see advertisements about falling interest rates and we’re told that if we don’t refinance right now, this “once-in-a-lifetime” opportunity will pass forever.
To be certain, refinancing can be extremely beneficial. It can restructure a loan to make it more manageable, it can reduce the monthly payments, help you pay off a loan faster, and, if done correctly, can even reduce the total amount you pay toward a mortgage.
But at San Diego Purchase Loans, we believe no decision involving your home or mortgage should be done in a rush.
Refinancing is a major decision, and anything involving your house, which is likely your largest asset, needs to be considered carefully, thoughtfully, and with a steady approach. But how can you make such an important decision. Where can you even start?
It’s a complex decision, and it involves countless factors, numbers, and variables. But like many complex decisions, by simply focusing on the most important issues, you can make the best choice for your personal situation.
To make the best choice, ask yourself these four essential questions. Once you reach a conclusion on these issues, you’ll be able to make the best decision on refinancing.
Four Important Questions To Ask Yourself Before Refinancing
1. What’s Your “Why”?
It’s the most basic, fundamental question, but it’s one that many homeowners can’t entirely answer. Why do you want to refinance? “To save money” is a common answer, but that’s not specific enough.
You need to go a little deeper…
Lower the Interest Rate
If you took out a mortgage loan when interest rates were high, there is a good chance that you can save money by refinancing to a lower rate. Even a 1% reduction in interest, assuming you have many months left on your loan and a significant loan balance, can result in tens of thousands of dollars in total savings. Currently, interest rates are historically low, which means many people are choosing to refinance their mortgage.
But there is another circumstance that can result in a lower interest rate. If you took out a mortgage when you had poor credit, you may have been forced to pay a higher interest rate. Successful lending is all about risk mitigation, and one of the ways to reduce the financial risk of lending to thousands of poor-credit borrowers is to charge a higher rate. Therefore, if you previously had a low credit score, but have since been able to improve your credit rating through steady payments, you may be able to refinance with a lower rate.
So how much can you save? To highlight the potential savings of a lower interest rate, let’s look at an (extremely) simplified example. In this case, we’ll look at a loan with 20 years (240 monthly payments) left on the loan and a remaining balance of $400,000. Using our Mortgage Calculator, we can find simply plug in a “House Price” (which represents the balance) of $400,000 and add zero downpayment. We then change the length of the loan to 20 years to get our total.
Under this circumstance, a 4.0% interest means a monthly loan payment of $2,424. However, if it is adjusted to 2.5%, we see the monthly payment reduced to $2,120, which is $304 lower than the previous loan. This would mean a total savings of $72,960!
Not everyone will be able to reduce the interest by a 1.5% (which is a significant decline), and this is a highly simplified example, but it demonstrates the outstanding potential that can come from refinancing.
Extend the Loan Terms
Another option is to extend the loan terms, which can make your monthly budget more manageable and free up cash for other purposes, including investments. By extending the loan terms, you will pay more, as there is more time for the interest to grow.
So let’s go back to the example above. Suppose you have 20 years remaining on a loan with exactly $400,000 on the balance. As we stated, at 4% this means a monthly payment of $2,424. Now suppose you refinance to a new 30-year loan. You keep the 4% interest (we’ll keep things as consistent as possible), but basically add another ten years to the terms. This reduces the monthly payment all the way down to $1,910. Yes, it means an entire decade of additional payments, and it will also mean a higher total cost, but it also reduces your monthly bills by over $500. For many borrowers, this is a big change that can significantly improve your finances.
2. Can You Qualify?
The other important consideration is whether or not you can actually qualify for the loan. In general, if you qualified for the previous mortgage, and your financial situation has not changed significantly, then you will likely qualify for refinancing.
If you have maintained your credit score, kept a sizable income, and made steady, on-time payments on your current loan, then you will likely qualify for a refinancing.
You also need to have owned the house long enough. Usually people need to have lived in their house for at least a year before the interest situation changes enough to make a difference.
3. Do You Understand the Real Cost of Refinancing?
If refinancing were free, it would happen all the time. But it costs money, which is why you need to take your time and understand the costs, which can then be weighed against the financial advantage.
Refinancing usually costs about 2% to 6% of the total loan amount, so the size of your loan can make a big difference.
The lender, your general location, and your credit score can also impact the overall cost. There are also fees, including fees for the application, origination, credit report, appraisal, and inspections. This can drive up the cost of refinancing and reduce the chances of realizing a benefit.
4. Can You Cover the Closing Cost?
The final question to ask yourself if quite simple: can you afford the closing costs. Even if you will realize a significant benefit to your finances, you need money in your savings account to refinance. Can you cover these costs without significantly harming your savings or placing a high amount of stress on your finances? If so, then you may be ready to refinance your loan and enjoy lower payments on your mortgage.