Should I Refinance?
Average mortgage rates have fallen to a 50- year low, according to Freddie Mac. This low- rate environment is projected to continue through 2021 with the Federal Reserve voting to keep interest rates near zero in the hopes it will encourage an economic rebound. For those looking to refinance, this is good news. So, what does it mean to refinance? Refinancing is the process of paying off your existing mortgage with the funds from a new mortgage. Refinancing isn’t for everyone; whether it makes sense to do so, depends on your specific situation. People choose to refinance for several different reasons.
Potential Reasons to Consider a Refinance
Obtain a lower interest rate – This is the most common reason for refinancing a mortgage. Acquiring a lower rate will save you money. Your monthly payments may be less, and you will be saving on interest. You can switch the term of your loan during a refinance as well. For example, changing from a 30-year loan to a 15-year loan. This can save you years in interest, as well as get you a lower interest rate on top of it. For example, a 15-year mortgage in the amount of $250,000 and with an interest rate of 2.17% will yield interest costs of around $43,100 over the life of the loan. A 30-year mortgage in the same amount at 2.67% interest would have higher lifetime interest costs of more than $113,600. Shifting from a longer-term to a shorter-term loan will also allow you to pay your loan off much sooner. For example, if you borrowed $200,000 over 30 years at 5%, the total payout would be $386,815. If you borrowed $200,000 over 15 years at 3.8%, the total payout would be $262,719. That’s a savings of $124,092 and 15 years less payments. Just remember, if you choose to refinance into a lesser term, your monthly payment will be higher. If a higher monthly payment isn’t feasible, or you don’t like the idea of having all that money locked up, there are other ways to pay down your loan faster. Making Bi-weekly payments (set up through lender), making one additional mortgage payment applied toward principal every year or apply extra money toward the principal every month.
Pay off debt – A cash-out refinance allows homeowners to tap the equity in their home to borrow money for things such as paying off high-interest credit card debt, medical bills, education costs, or to upgrade their home or cover costly home repairs. To illustrate, if you had $20,000 in credit card debt at 20% annual interest rate, that translates to over $300 per month in interest costs. Say you are able to lock in a 3% rate on your refinance loan, you would essentially be paying that debt at a rate of 3% rather than 20%. However, keep in mind that paying off credit card debt with a mortgage also causes the repayment period to be 15-30 years (depending on the term you selected) on credit card loans. So, if doing a cash-out refinance to consolidate debt, it is in your best interests to add an appropriate extra amount of principal to your new mortgage payment so the credit card debt will be paid off within three years. Interest rates for a cash out refinance are a bit higher than that of a standard refinance or new mortgage. Most lenders require 80% loan to value (LTV) for a cash out refinance as well.
Drop PMI – Private mortgage insurance (PMI) is a financial tool that helps you purchase a home with a small down payment. The borrower pays the insurance premium, and the lender is the beneficiary. Mortgage insurance is paid to the lender should you default on your home loan. FHA loans typically carry higher rates as well as this extra expense (PMI). The cost of PMI is based on several factors including your FICO score, loan to value and coverage required, state of residence, and adjustments. To illustrate, if $150,000 was borrowed and the annual premiums cost 1%, the borrower would have to pay $1,500 each year ($125 per month) in PMI. When home prices increase, the value of homes also increase, which generates more equity. You can refinance to a conventional loan and drop your PMI once you have 20% equity in your home.
Your credit score has improved – If your credit score has made a significant jump, chances are you can obtain a better interest rate, which can shave thousands of dollars off your loan costs. Make sure you are checking your credit report/score every year.
Costs Associated with Refinancing
There are always costs to consider before making financial decisions. Starting December of 2020, a new fee went into effect specifically for refinances. The Federal Housing Finance Agency (FHFA) started charging a refinance fee called the “adverse market refinance fee.” It is a 0.5% fee charged to refinances sold to Fannie Mae or Freddie Mac (about 79% of all loans). It is designed to help Fannie and Freddie offset some of the estimated $6 billion in COVID-19 related losses they expect will stem from defaults and forbearances. There are some exceptions to this fee. Borrowers refinancing VA loans and FHA loans are exempt, as are new homebuyers and those with a principal balance less than $125,000. Some lenders roll the fee into the interest rate and others add it as a one-time fee within the closing costs.
Typically, you are charged closing costs during a refinance. These costs can be, and often are, rolled into the new mortgage thus increasing your monthly payments. These costs can range anywhere from 2% to 5% of your loan amount depending on where you live, the price of your home, and the lender. Some lenders offer a no-cost refinance, which means you won’t pay closing costs upfront. However, you are still paying for these costs because they either wrap them into the mortgage principal or increase your interest rate.
It is important that your monthly savings offset these closing costs. It is wise to do the math to determine how long it will take before the monthly savings of your new mortgage exceed that of your closing costs. This is known as the “break-even point.” To get an estimate, divide the amount of your closing costs by the amount you save each month. There are also online calculators that help you calculate your break-even point and ultimately help you determine if refinancing will save you money.
What Determines My Interest Rate?
The interest rate you end up with is determined by several factors. Some specific to your personal situation such as credit score and history, debt to income ratio, loan to value ratio, the size of your down payment, the type, term and size of loan selected and more. Other factors are more macro in nature like overall economic strength and stability, inflation rates, consumer spending, employment data, financial markets, and of course Federal Reserve policies.
There are many online services like Lending Tree and Credible that can help you shop rates by reaching out to multiple lenders at a time.
The key takeaway is that right now, rates are extremely low. It is worth the exercise of running the numbers to see if a refinance makes sense for you.
The Motley Fool. (December 2020). 3 Mortgage Refinance Strategies to Consider in 2021.
3 Mortgage Refinance Strategies to Consider in 2021 (fool.com)
Forbes Advisor. (December 2020). A New Mortgage Refinancing Fee Begins Today. Here’s What You Should Know.
A New Mortgage Refinancing Fee Begins Today. Here’s What You Should Know – Forbes Advisor
CNN Underscored. (September 2020). How to Refinance Your Mortgage: Rates & Fees.
How to Refinance Your Mortgage: Rates & Fees | CNN Underscored
CNN Underscored. (November 2020). Cash Out Refinance – Pros and Cons.
Cash out refinance — pros and cons | CNN Underscored
Main Street Advisors, LLC. January 2021. Main Street Advisors, Inc. is a Registered Investment Advisor. The articles and opinions expressed in this material were gathered from a variety of sources, but are reviewed by Main Street Advisors, LLC, prior to its dissemination. All sources are believed to be reliable but do not constitute specific investment advice. The views expressed are those of the firm as of January 2021 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Any advice given is general in nature and investors must consider their own individual situation. Always contact your financial/investment professional before making any financial decisions. Main Street Advisors, LLC is not responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.