Personal Finance

Home Loan Basics: Reasons to Refinance

Jun 20, 2019

Whether it’s been ten months or ten years since you purchased your home, you may find yourself occasionally mulling over the idea of refinancing. The thought may have been triggered by a news story about a sharp decline in interest rates, an unsolicited email promoting lower monthly payments, or a conversation overheard at the local coffee shop. Fluctuations in interest rates are often the force that drives borrowers to refinance, but a number of other situations can cause borrowers to consider replacing their old loans with new ones. Let’s explore the most popular reasons borrowers choose to refinance, as well as review a few things to consider before making this financial decision.

A drop in interest rates is not the only reason to consider refinancing your existing mortgage.

Popular Reasons Borrowers Refinance

Reasons to refinance an existing mortgage can fall into a number of categories. Most focus on saving money in either the short term or for an extended period of time. Others involve using a borrower’s equity in a home for another purpose. And another is related to the ownership of the property and who’s responsible for the loan.

Obtaining a Lower Interest Rate

A better interest rate may be the most popular reason to refinance. The opportunity to get a lower interest rate is something many borrowers don’t want to pass up. After all, a lower interest rate could potentially save a borrower thousands of dollars over the life of the loan. Securing a lower interest rate isn’t only dependent on the market. It can also be influenced by more personal factors, such as a borrower’s credit score, debt-to-income ratio, financial history, or the current value of their home. Even a change in loan products could offer a borrower an improved interest rate.

Decreasing the Monthly Payment

Sometimes the driving force behind a refinance is to achieve a lower monthly payment. A lower mortgage payment could allow the borrower to pay off another expense or provide some breathing room in an otherwise tight budget. Often a lower interest rate will also result in a lower monthly payment. However, a lower interest rate isn’t the only way to reduce a monthly mortgage payment. Borrowers can also meet this goal through a comparable interest rate and a longer loan term.

Shortening the Loan Term

Other borrowers have the goal of paying off their loan as quickly as possible. For them, refinancing to a shorter term can help them achieve this goal sooner. A drop in interest rates could allow a borrower to shave a few years off their loan term without a huge jump in the monthly payment. Plus, there is the added benefit of reduced interest expense over the life of the loan. If refinancing turns out not to be an option, a shorter loan period could also be achieved by the borrower paying a little extra each month to reduce the principal balance.

Switching to a Fixed Interest Rate

Adjustable Rate Mortgages (ARMs) are a popular product, with common fixed interest rate periods of 3, 5, 7, and 10 years. However, many borrowers eventually replace these loans with fixed rate products. This is especially true for borrowers facing an interest rate adjustment period in the very near future. When the fixed rate period comes to an end on their ARM loan, many borrowers are eager to lock in another low fixed rate. This could be in the form of a new ARM product or a fixed rate loan that offers the same interest rate for the entire loan term.

Funding Home Improvements

Borrowers build equity in their homes through monthly mortgage payments, increases in home values (appreciation), or both. A refinance of their existing mortgage can often allow them to use some of their equity for home improvement. By replacing their existing mortgage with a larger loan, they can obtain the cash they need to make home improvements or repairs. Instead of taking out a personal loan or charging the expense to a credit card, they can finance the cost at a lower interest rate through a new mortgage.

Paying Off High Interest Debt

Because home loans typically offer among the lowest interest rates, borrowers with other high interest debts may benefit from cash-out refinances of their existing mortgages. The new loan will include the amount to pay off the old loan, plus cash to the borrower to pay off the high interest debt. Generally, the new loan amount should not be more than 80% of the borrower’s home value. Otherwise, the borrower would likely have to pay the added expense of private mortgage insurance (PMI).

Obtaining Cash for a Specific Purpose

There are times when borrowers use a cash-out refinance to fund other major expenses. The borrower can use the cash from the refinance for just about any purpose, including college tuition, medical expenses, legal bills, etc. Borrowers will want to keep in mind that they are using their homes as collateral for these expenses and make sure their new loan payment fits into their monthly budget. A personal loan can be another option for borrowers to explore when they face a large expense, especially if they have limited home equity.

Eliminating Private Mortgage Insurance

For borrowers who have existing home loans with private mortgage insurance (PMI), a refinance may help them eliminate the expense and lower their monthly payments. With a few exceptions, borrowers pay PMI when they finance more than 80% of their home’s value at the time of purchase. However, over time, their loan-to-value may move under 80%, which can allow them to refinance to a new loan and eliminate the expense of PMI. This may be especially true if the borrower has an FHA loan, which generally doesn’t allow cancellation of PMI, regardless of the borrower’s loan-to-value.

Changing Borrowers

Frequently mortgages have more than one borrower. Often individuals buy a property together and are co-borrowers on the mortgage. The co-borrower could be a spouse, parent, child, sibling, other relative, or even a friend. Over the life of the loan, there may be a need to remove an existing borrower or add a new borrower. Either way, the most common way to change the borrower on a home loan is through a refinance.

Things Borrowers Should Consider When Refinancing

When considering a refinance, it is important to weigh the pros and cons of a new loan. There are a number of areas you can explore to help you evaluate the benefits of refinancing your loan.

Time Since Your Purchase or Last Refinance

How long has it been since you got your loan? Although there is really no limit to the number of times you can refinance your home, many lenders require a minimum amount of time between home loans. The requirement varies by lender and product. A common waiting period is often 6 months, but it could also be a minimum of 4 months or even 7 months or more. It depends on the loan product and the lender’s requirements.

Length of Time You Plan to Keep Your Home

Give some thought to how long you plan to keep your home. A lower interest rate can add up to large savings over the term of the loan. However, if you’re planning to sell your home within a year or two, your monthly savings from a lower interest rate may not add up to enough to cover the actual cost of the loan.

Calculating Your Break-Even Point

When the goal of refinancing is to save money through a lower interest rate, it is helpful to calculate a basic break-even point for the new loan. It’s the estimated point at which your monthly savings from the refinance cover the costs of the new loan. For example, if the cost of the refinance is $2,400 and you will save $120 a month in interest, the break-even point is 20 months. After 20 months, the cost of the refinance will be covered by the amount you have saved each month in interest expense.

Your Current Credit Score

Your credit score has an impact on the interest rate you are offered. Generally, the higher your credit score, the lower the interest rate offered. If your credit score has risen since your last loan, an improved interest rate may now be available to you. On the other hand, if your credit report has taken a hit in the last year or so, you may have fewer options for a lower rate. You can get a free annual credit report from each of the credit agencies to review before you apply for a loan.

Your Existing Loan Type

There are many different loan programs available for your consideration when refinancing. However, your existing loan type may offer a streamlined refinance program that could potentially save you time and money. The Interest Rate Reduction Refinance Loan (IRRRL) is a streamlined refinance program available for VA-to-VA refinances. For borrowers with FHA loans, there are streamlined programs available for lower interest rates and also a cash-out refinance option. These programs offer some unique benefits; however, a borrower will benefit from exploring a number of different loan types before settling on one.

Closing Costs

Like interest rates, closing costs often have an influence on a borrower’s decision to refinance a loan. They are often rolled into the new loan amount, but they can also be paid directly by the borrower. Closing costs can vary widely among lenders. Some lenders offer low interest rates with slightly higher closing costs. Other lenders have reduced closing costs with slightly higher interest rates. When evaluating offers, you may find it helpful to calculate break-even points for each, taking into consideration the length of time you expect to have the loan.

When Does Refinancing Make Financial Sense?

Refinancing makes sense when the borrower receives an actual benefit from replacing an existing loan with a new one. A mortgage refinance can offer an improved financial position for many borrowers, either through a lower interest rate, reduced monthly payment, or the elimination of high-interest debt. When exploring refinance options, borrowers should be aware of the cost of the loan, as well as the time they plan to keep their loan.

A mortgage refinance should be tailored to your individual needs and goals.

When interest rates decline, you may have an opportunity to save money through a mortgage refinance. However, you don’t need to wait for a major drop in interest rates to explore the benefits of refinancing. Whether it’s a good time for you to refinance depends on your individual situation and your specific plans for the future.

The experienced Mortgage Specialists at Axos Bank can help you explore your refinance options and review the benefits of refinancing. To learn more, please call us at 888-546-2634.