When you take out a new loan and pay off and replace the old loan, it’s called refinancing. Usually, the goal of a refinance is to lower the monthly interest rate or payment, and there are some common reasons to refinance, all in the name of saving money in the long run.
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Common Reasons to Refinance
Shorten the term: If you can afford to shorten the term of your mortgage loan, you could save significantly over the life of the loan.
|30-year fixed rate @ 4.5% for $100,000||15-year fixed rate @ 4.00% for $100,000|
|Principal and interest payment: $507||Principal and interest payment: $740|
|Total interest paid for 30 years: $82,407||Total interest paid for 15 years: $33,144|
|Savings over the life of the loan: $49,263|
if you shorten the term from 30 to 15 years, the rate will be slightly lower, but the monthly payment will be higher. Throughout the loan, you’ll pay nearly $50,000 less in interest. Even $2,000 in closing costs makes this option a real savings benefit if you can afford the monthly payment plus taxes and insurance.
If you stretch your budget for the higher monthly payment, you can consider another alternative. Leave your mortgage at a 30-year term but make the higher 15-year payment if you can. The savings won’t be quite as significant, but if an unexpected emergency crops up you won’t be contractually obligated to pay the higher payment and can revert to the lower regular payment until the temporary hardship is resolved and higher payments can resume.
In the example above, if you wanted to pay off $100,000 at 4.5% in 15 years instead of 30, you would need to pay $765. The extra $258 would apply to the principal, reduce your balance faster and paying $44,708 less in interest over the life of the loan.
You can use a mortgage amortization schedule calculator to work all these figures.
Lower the interest rate: If rates happen to drop, you might be interested in a lower interest rate to save on your monthly payment over the life of the loan. It is wise not to add to the term of the loan but refinance based on the number of payments you have remaining in your loan. For example, if your current balance is $100,000 and the original loan was 30 years, and you’ve paid ten years you would want to refinance to a 20-year term. Depending on the rate and closing costs, it might be beneficial for you to refinance but you should run some numbers to see if the difference in rate justifies the cost.
|$100,000 over 20 years @ 5.5%||$100,000 over 20 years @ 4.5%|
|Principal and interest payment: $688||Principal and interest payment: $633|
|Total interest paid: $65,093||Total interest paid: $51,836|
You would be saving $55 in your monthly budget and #13,257 over the life of the loan. Account for a couple thousand in closing costs and your savings is around $10,000, which might be worth it. If the refinance rate was only a quarter percent lower at 5.25%, your monthly savings would be $14 and over the life of the loan $3,370, which would barely cover the closing costs. You’ll have to check and make sure the lower rate is worth the cost.
Lower the monthly payment: You can see the calculation above and see the savings in monthly payments as it correlates to the interest rate. The above example only lowered the monthly payment by $14.
If your budget requires you to lower your monthly payment, you can choose to refinance and extend the term back out to 30 years, and your monthly payment will go down, but you will pay more interest over the life of the loan.
|$100,000 original loan (30 Year at 4.5%)||Balance after 10 years: $80,000 refi back to 30-year at 4.5%|
|Principal and interest payment: $507||Principal and interest payment: $405|
|Total interest paid: $82,407||Total interest paid: $65,925|
During the first ten years of the original loan, you would have paid nearly $40,000 in interest and refinancing to a longer-term means you paid that previous $40,000 plus the $65,925 for the new loan. Compared to the original loan, you will pay approximately $23,518 more in interest. When you extend the term, you’ll see short term savings on your monthly budget, but you will pay more in interest over the life of the loan.
Switch from an adjustable-rate mortgage to a fixed-rate mortgage: Refinancing from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage can be beneficial. An ARM means that the loan is subject to rate adjustment over time. The initial rate is fixed for some time, and then it adjusts on a specific schedule and is tied to a publicly published rate with a designated margin markup. For example, a 3/1 ARM loan means the initial rate is fixed for three years, but then it adjusts each subsequent year following the third year.
For example, if the 3/1 ARM is tied to the U.S. prime rate and the loan originated in January of 2009, the Prime Rate was 3.25% plus a margin of 1% the initial rate would have been 4.25%. The loan would remain at that rate until January 2012 and since the prime rate did not increase in 2012, that rate would remain in effect. In January of 2018, the prime rate was 4.5%, and with a margin of 1%, the newly adjusted rate would be 5.5%. Assuming an original loan amount of $100,000 amortized over 30 years, the payment over this period would increase $76 per month. If the rate continues to rise over the life of the loan, the payment increases as well.
A refinance can help to fix the rate and payment to stop the payment from increasing. If you have an ARM, you might want to check your original loan documents or ask the lender if there is a conversion option. Some ARM loan products offer the potential to convert the loan from an adjustable to a fixed-rate loan for a flat fee rather than paying full closing cost.
Cash-out for debt consolidation: Another common reason for borrowers to refinance their mortgage is to cash out the equity in their home. Homeowners can use the equity in their home to pay for home improvement projects, college education expenses or pay off other existing debt. Since a home loan is secured by a home, the rates are typically lower than other types of financing, especially unsecured personal loans or credit cards. Refinancing with cash out to pay off debt can save you money in the long run and pay off the debt much faster.
You will need to determine how much equity you have in your home to see if this option might work for you. First, estimate how much the home is worth. You can look at an old appraisal or the fair cash value on your tax assessment if that information is provided. Next, determine how much you own on the mortgage. Most lenders won’t lend more than 90% loan to value. Multiply the home value by 90%, and that is the maximum amount of money you can borrow against your home. (Home value of $100,000 * 90% = $90,000)
Take the 90% value limit minus what you currently owe and that number is a rough estimate of the amount of equity remaining that you can borrow against. (90% LTV limit $90,000 – current mortgage balance $50,000 = $40,000 in potential equity to borrow against)
Is the Refinance Worth it?
The answer to this question depends on your reasons for refinancing. If you are looking to save money in your monthly budget, you’ll evaluate your options differently than if you are looking to save money long-term. Depending on your reasons, you’ll need to determine if the refinance is worth paying closing costs again.
Do you Qualify for a Refinance?
The loan criteria for a refinanced mortgage loan is like the purchase. Your financial situation will be reevaluated and new documentation will be collected, including a new appraisal on your property.
Credit score: The lender will check your credit report. You may want to pull your report beforehand (you can pull each credit bureau once a year for free if you want the scores you may be required to pay). Clean up any credit report errors and collections if possible. The better your score, the better your credit terms. If you must pay more in interest, you might limit your sales price range of shopping. Most lenders look for a minimum of a 640 credit score, so if you’re on the low side, you might want to wait and work on improving that score first.
Monthly debt: The lender will determine your total monthly debt obligations. Add up all your monthly loan payments including credit cards and deferred student loan debt at 1% of the balance. The lender will calculate your debt to income ratio (DTI):
Lenders look for DTI ratios under 43%. They will sometimes evaluate higher figures, but the interest rate might be significantly higher.
Income: Be prepared to bring your most recent two paycheck stubs and last year’s W-2. For self-employed borrowers, you will need to bring your last two years of tax returns.
Frequently Asked Questions
1) Q: How do I get pre-approved?
First, you need to fill out an application and submit it to the lender of your choice. For the application you need 2 previous years of tax returns including your W-2’s, your pay stub for past month, 2 months worth of bank statements and the lender will run your credit report. Once the application is submitted and processed it takes anywhere from 2-7 days to be approved or denied. Check out our top lenders and lock in your rate today!
2) Q: How much interest will I pay?
Interest that you will pay is based on the interest rate that you received at the time of loan origination, how much you borrowed and the term of the loan. If you borrow $208,800 at 3.62% then over the course of a 30-year loan you will pay $133,793.14 in interest, assuming you make the monthly payment of $951.65. For a purchase mortgage rate get a quote here. If you are looking to refinance you can get started quickly here.
3) Q: How much should I save for a down payment?
Most lenders will recommend that you save at least 20% of the cost of the home for a down payment. It is wise to save at least 20% because the more you put down, the lower your monthly payment will be and ultimately you will save on interest costs as well. In the event that you are unable to save 20% there are several home buyer programs and assistance, especially for first time buyers. Check out the lenders that specialize in making the home buying experience a breeze.
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