Should You Take Advantage of Low Rates and Refinance Your Mortgage?
Throughout 2020, we witnessed a lot of ups and downs in the market — particularly the real estate market. With homes in higher demand than ever before, housing prices began steadily increasing. Mortgage rates, however, hit historic lows towards the end of the year, leaving many to contemplate purchasing a home or refinancing their existing home loan.
What caused rates to dip so low? I’ll show you why you might want to lock in rates now to save thousands on your home loan.
The impact of 2020 and the pandemic on mortgage rates
The coronavirus pandemic played a large role in lowering mortgage rates. When the economy is uncertain or shaky, the Federal Reserve tends to lower interest rates to stimulate market growth. In addition, when the economic outlook is unclear, many investors begin purchasing bonds instead of stocks, which plays a direct role in lowering mortgage rates.
To put this into context, mortgage rates have typically hovered around 4% (on average) for the past decades, with some years dipping below and others rising above this percentage. However, 2020 saw an average 30-year mortgage rate of 3.11%, the lowest average in history. The end of the year even saw average rates below 3%, with December averaging a mortgage rate of 2.68%.
All this is to say that rates are currently so low that many homeowners who weren’t considering buying real estate or refinancing are taking a second look. But is now a good time to refinance? I’ll walk you through the questions you should ask before taking out another home loan.
What is mortgage refinancing and how does it work?
Refinancing refers to taking out a new home loan to replace your original mortgage. When you refinance, the money you take out is used to pay off your first home loan, leaving you with a new mortgage rate and loan term. Typically, homeowners decide to refinance when rates are low to save money on interest.
When’s the best time to refinance?
Even though rates are at historic lows, that alone doesn’t mean it’s a good idea for you to refinance your home. If refinancing will save you money on your home loan and allow you to build up home equity and pay off your mortgage faster, then it’s typically a smart financial decision.
To decide if now is the right time to refinance, you’ll want to review your current mortgage terms and make sure you can secure a lower interest rate. You’ll be able to secure lower monthly mortgage payments if you’re able to reduce your home loan interest rate by 0.50% to 0.75%. Since last year’s average mortgage rate was 3.94% and 2021 rates are averaging under 3%, it’s possible to notice significant savings by refinancing.
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Ways to refinance your home loan
Everyone refinances for different reasons. As a result, there are several different ways to refinance. Knowing your mortgage term, current interest rate, and financial goals can help you determine the right refinancing method for your home.
Standard refinancing
If you want to save money on your home loan and have a 30-year or 15-year fixed-rate mortgage at a higher interest rate than the current average, standard refinancing will likely make the most sense for you. In this process, you’ll secure another 30- or 15-year loan (or you can ask the bank to meet your current remaining terms) to replace your existing mortgage. Locking at a lower rate will allow you to save money each month while building equity in your home much more quickly.
Adjustable to fixed-rate refinancing
Any homeowner with an adjustable-rate mortgage might be considering refinancing to obtain a fixed-rate mortgage at today’s low rates. This will likely save you money in monthly payments, but more importantly, will provide you with more predictable payments, since your rate will be locked in and your monthly payment will remain the same throughout the duration of your new loan.
Mortgage term reduction refinancing
Low interest rates make it possible for homeowners to reduce their home loan terms and pay off their mortgage even faster by changing a 30-year home loan to 15-year terms. Doing this might increase your monthly payment, but depending on your current interest rate, your monthly payment amounts might decrease. However, the real victory here is paying off your loan sooner and saving thousands of dollars in total interest charges by reducing your loan term.
PMI elimination refinancing
If you put less than 20% down on your home originally, you likely have some form of private mortgage insurance (PMI). While PMI typically is no longer required once you reach 20% equity in your home, some conventional loans and FHA loans require you to continue paying for mortgage insurance for the duration of the loan. To save on this cost, once you reach 20% equity, you can refinance your mortgage to eliminate the need to pay for PMI.
Home equity refinancing
Lastly, some homeowners might choose to refinance to tap into their home’s current equity. This type of refinancing strategy, also known as a cash-out refinance, allows you to take out a larger loan amount than you currently owe on your home with a new refinanced mortgage. You’ll then be able to cash out the difference between the cost of the home and the new home loan. Many homeowners use this strategy to pay off business expenses, high-interest debt (such as credit cards), medical bills, or to cover construction costs.
Getting approved for a refinancing home loan
Even if you have a good reason to refinance your mortgage, it’s important to understand the criteria you’ll need to meet to get approved for a new home loan — particularly at the low rate you’re hoping to secure.
Like always, every lender has their specific qualifications, but here’s what lenders typically look for when approving a refinance loan.
Minimum of 20% equity in your home
While it is possible to get approved for a refinancing home loan if you have close to 20% equity in your home, most lenders won’t approve you until you reach this milestone. If you put 20% down when you originally bought your home, then you already meet this requirement. However, if you put a smaller amount down, you’ll need to figure out how much equity you currently have in your home.
To do this, you’ll take your most recent mortgage balance and subtract it from your home’s recent estimated value. So, if your home is worth $300,000 and your home loan balance is $235,000, you’ll be able to figure out that you have $65,000 in home equity. Divide your home’s value by this number to get your equity percentage ( $65,000 / $300,000 = 0.2166 or 21%).
If your home equity is less than 20%, it’s likely best to wait until you’re near this number to begin applying for a refinancing loan.
Credit score of 620+
Next, you’ll want to review your credit report to make sure there are no negative remarks or reasons for a lender to turn down your application for a new home loan. Be sure to check your credit score and if it’s under 620, work to boost your score by making on-time payments, paying off high balances, and keeping your credit utilization under 30%.
Even if your score is above 620, you can use these tips to help you increase your likelihood of getting approved for a lower rate.
DTI ratio (debt-to-income) under 43%
Another important factor banks will look at when reviewing your refinancing mortgage application is your debt-to-income (DTI) ratio. In general, lenders like to see DTI ratios under 43%, but the lower, the better.
You can figure out your DTI by taking your monthly debt payments (home loans, credit cards, and other loans) and dividing this number by your monthly pre-tax income. For instance, if you pay $1,700 a month for debt and make $4,500 a month pre-tax, you would get 0.3777 or 38%.
If your DTI is above 43%, see if you can pay down large credit card balances to reduce your monthly debt expenses and lower your DTI.
Other factors to consider before refinancing
Once you’ve determined that you’ll be approved for a refinancing mortgage, you’ll also want to make you consider whether this decision makes the most financial sense for your situation. Here are a few factors to review before moving forward with refinancing.
Loan terms
I’ve already discussed that opting for a shorter term for your fixed-rate loan can increase your monthly payments, but save you thousands in interest payments in the long run. However, if your goal is to save money each month, it’s important to understand how stretching out your loan terms impacts your mortgage.
Let’s say you’re 7 years into a 30-year mortgage right now. If you refinance and opt for another 30-year mortgage to save money on your monthly payments, this means you’ll be paying on your home for an additional 7 years. You could even end up paying more long-term interest, thanks to the extended loan terms.
Depending on your current mortgage rate and how far you are into your mortgage term, it is possible to reduce your monthly payment and still pay off your mortgage on time. Be sure to ask lenders if they’ll reduce your loan terms to match your current home loan (in the above example, that would mean lowering the terms to 23 years). This can still offer you monthly savings, without stretching out the life of your mortgage.
Closing costs
I’m sure you remember saving for closing costs when you first bought your home. When refinancing, you’ll also need to have cash available to cover closing costs. These costs include agent fees, origination fees, and other administrative expenses. Closing costs will vary by state but typically are between 2% to 5% of your mortgage principal.
If your refinancing mortgage is for $300,000, for example, expect to pay $6,000 - $15,000 in closing costs. Mortgage lenders also tacked on a new fee in December of 2020 for refinancing loans, adding 0.5% for refinancing loans over $125,000.
If you can’t get these funds together, it’s best to hold off on refinancing until you have extra savings to pay for closing.
Break-even point
You’ll also want to understand how long it will take you to recoup your closing costs to ensure you recover this money before selling your home. You can figure this out by calculating your break-even point, or the timeframe it will take you to recover your upfront home refinancing expenses. If your closing costs are $10,000, you’ll want to make sure you save at least this amount in interest before considering selling your home.
You can figure this out by taking the number you’re paying in closing costs ($10,000) and divide it by the monthly savings of your new mortgage. If you save $250 a month with your new refinanced home loan, divide $10,000 by $250 to get 40. This is how many months it will take you to recoup your closing costs.
So, if you plan on selling within the first three years of your refinancing loan, you’ll end up losing money. In addition, since most mortgages have prepayment penalties, you won’t be able to attempt to pay more of your mortgage off early without incurring additional fees.
Financial hardship
While refinancing can offer a straightforward way to save money on your home loan, it’s worth exploring other options, particularly if you’re struggling to pay your mortgage in full each month. Take a look at your current finances and average mortgage rates to decide if saving an extra $100 - $200 will make it easier for you to continue paying for your home.
If the answer is no, you might want to avoid draining your savings on closing costs and instead explore other options. These might include taking advantage of the CARES Act extended forbearance period of up to 360 days or selling your home.
In some cases, refinancing your mortgage can prevent you from going into foreclosure. It’s important to shop around and see how much you could save on a new home loan with different lenders before deciding if refinancing is the right decision for your household.
FAQs
How long does refinancing a home take?
Closing on a home has sped up in recent years and now you can expect to refinance a home within 30 days. Working with a professional real estate agent can improve your chances of closing quickly on a home, particularly if you’re hoping to lock in a low interest rate. Keep in mind, you’ll need to ensure you provide all required documentation and closing costs on time to ensure a speedy underwriting and closing process.
Are mortgage rates going to get even lower?
Mortgage rates have been at their lowest over the past year and a half, but it’s impossible to predict if they’ll continue getting lower. Although financial experts do expect rates to remain low for years, any change in the market could cause a spike or drop in mortgage interest rates.
It can be a gamble to bet that rates will continue to drop, so if you’re looking to refinance in the next 1 - 2 months, I recommend pulling the trigger now. If you won’t be ready for refinancing until later in 2021, then pausing on this decision makes good sense.
How can I secure the lowest refinancing rates?
I always suggest shopping around at different mortgage lenders when considering refinancing. Find out which lenders will offer the best rates and terms to suit your financial needs. To boost your chances of receiving a low mortgage rate, be sure your credit is in good standing and your DTI is low.
Does refinancing hurt your credit score?
When you apply for new home loans, each lender will make a hard inquiry into your credit report, which can ding your score slightly. Once you accept a refinancing mortgage, taking on this new debt might also lower your score, though the impact should be minimal.
Can I refinance if I just bought a home?
Many homeowners who bought a house early in 2020 might get approved for mortgage rates that are as much as 1% below their current loan rate. To take advantage of these lower rates, however, you should have at least 20% of your home’s equity.
The bottom line
Now is an opportune time for many homeowners to refinance their home loans and lock in lower mortgage rates. Although low mortgage rates are unlikely to disappear anytime soon, if you’re in a position to refinance, taking the necessary steps now can help you realize hundreds in monthly savings.
First, decide what type of refinancing situation makes the most sense for your finances, then ensure you’re qualified to be approved for a new home loan. From there, the process of securing a refinancing mortgage is fairly straightforward and 30 days from now, you could be saving hundreds on your monthly payments.
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