When you refinance your mortgage, you take out a new loan at a lower interest rate or for a different term and use the proceeds to pay off the original mortgage; you’re basically replacing one mortgage with another one that will lower your current monthly payment and (hopefully) your total interest costs. Most lenders require you to have at least 10 to 20 percent equity in your home before you can refinance.
When mortgage rates start to drop, homeowners start to think about refinancing. While lowering your interest rate is a key factor in this decision, it’s not the only thing to consider. Refinancing may make sense if you have a second mortgage or home equity loan with a higher rate, you want to take advantage of lower interest rates to shorten the term of your loan for around the same monthly payment, or because you want to trade in your ARM for a fixed-rate loan.
How can you tell whether refinancing makes good financial sense? The general rule of thumb says that interest rates should be at least 1 percentage point below your current rate, but sometimes making even a half-percentage change can be a good move. Since refinancing a mortgage comes with loan closing costs, you want to make sure that the rate change will save you more than the loan expenses. You can run those numbers using an online refinancing calculator, available on most mortgage lender websites and on sites such as SmartAsset and NerdWallet.
Credit Check
Be aware that you may not qualify for the low interest rates you see advertised. When you apply for refinancing, the lender will do a credit check, and if your credit score isn’t excellent, you’ll pay a higher rate.
Sometimes refinancing doesn’t make sense. For example, if lowering your interest rate and monthly payment leads to paying more interest over the life of your loan (which can happen if you extend your loan term), refinancing doesn’t make sense. It also doesn’t make sense to refinance if you can’t afford to pay closing costs out of pocket, and you need to roll them into your loan; then you’ll end up paying fifteen or thirty years’ worth of additional interest on those costs. Finally, if you’re planning to sell your home within five years, refinancing will end up costing you more than it’s worth.
Some people refinance for more than the value of their current mortgage if they have enough equity in their home. This is called cash-out refinancing, and it can damage your overall financial situation. Cash-out refinancing increases your debt and the amount of interest you’ll pay to the lender (the opposite of why you would want to refinance), so consider that carefully before you choose this type of loan.
Let’s say you paid $125,000 for your house, and your mortgage is $100,000. Your house has appreciated in value and is now worth $175,000. You might refinance for $140,000, pay off the balance on your $100,000 mortgage, and take the difference of $40,000 or more in cash. You’d still have 20 percent equity in your home ($140,000 ÷ $175,000 = 80 percent), but without the cash-out your equity would stand at nearly 60 percent. If your home value declines, your equity percentage will drop even further, potentially leaving you “under water” (your mortgage loan will exceed the market value of your home).
Don’t forget that your monthly payments could be significantly higher because of the higher loan balance, even though your interest rate was lowered by the refinance, so make sure you can afford them. In most cases, cash-out refinances won’t serve your long-term financial health; in fact, these loans can damage your financial future. However, if you’re planning to borrow anyway to make improvements to your home, this may be the way to go instead of taking out a second (possibly more expensive) loan to pay for the renovations. In the event that you cash out for purposes other than home improvements, the tax deductibility of the mortgage interest related to the refinancing may be limited. See IRS Publication 936 for the details.
Many people do not realize that all mortgage interest isn’t always fully tax-deductible, even on your primary residence (the home you live in). The government recognizes two different types of mortgage interest: acquisition indebtedness and home equity indebtedness.
With acquisition indebtedness, you may not deduct interest for more than $750,000 of debt (or $1 million of debt acquired before December 14, 2017) related to the acquisition of your primary home plus one second home. Acquisition indebtedness means a mortgage incurred in order to acquire, construct, or substantially improve a qualified home. If you also have home equity indebtedness, that loan amount has to be included in the $750,000 cap, and the proceeds must be used to buy, build, or substantially improve your home in order to be tax-deductible.
You can shave thousands or tens of thousands of dollars off the long-term costs of your mortgage by prepaying. There are several ways to do it. You can add a little extra to your regular monthly payment, make one extra payment a year, or pay half your regular payment every two weeks (if your lender allows that), which equates to paying an extra full payment each year.
What to Pay First
Please note that when mortgage rates are significantly lower than other consumer borrowing rates, it makes more sense to pay off any higher-interest debts (including credit cards and student loans) first. When you make extra payments, be sure to tell your lender to apply them to the principal. If you pay online, you may be able to check a box that says something like “additional principal payment,” or there may be a similar line on your payment coupon (if you pay by check). Before making prepayments, check with your lender and read the fine print of your loan documents to make sure your lender won’t penalize you for prepaying part of your mortgage in the first three to five years of the loan.
If you had a thirty-year mortgage for $100,000 at 4 percent interest and you put an extra $25 toward principal every month, you’d cut nearly three years off the length of the mortgage and almost $7,500 in interest.
Even if your loan does have a prepayment penalty, you’ll probably be allowed to prepay up to 20 percent of your mortgage in any twelve-month period without incurring a penalty, so adding $25 or $50 to your monthly payment wouldn’t trigger that penalty.
If you fail to make your mortgage payments for ninety days without communication with your lender, your lender may start foreclosure proceedings to take over your house and sell it to get back the money they lent you. If the house sells for less than you owe on it, they could sue you for the difference. A foreclosure would force you out of your home and significantly impact your credit record and your financial future, so try to take every step possible to avoid this outcome.