Whether you’d like to switch from a variable to a fixed interest rate mortgage, lock in a lower interest rate, change your payback schedule, or tap into your home’s equity with a cash-out refinance, there are many things to consider before taking the plunge. We put together this mortgage refinance guide to explain the pros and cons of mortgage refinancing, how to refinance a mortgage, and to help you decide if or when to refinance your home.
What Does Refinancing Mean?
Mortgage refinancing means replacing your existing mortgage with a new loan. You would have to fill out the same kind of paperwork and application for your new mortgage that you did for your original mortgage. Your lender will check your financials such as your income and credit score and hire an appraiser to determine your home’s current market value.
Rate-and-Term vs Cash-Out Refinances
One of the primary considerations when refinancing a mortgage is whether to opt for a rate and term option or a cash-out mortgage. A rate and term mortgage is a more straightforward option because you’re swapping an old mortgage with a new one with different terms.
A cash-out refinance lets you take advantage of the equity you’ve built up in your home, from making regular loan payments and from any increases in property values since you obtained your mortgage. You can use that equity to pay off your existing mortgage and receive a lump sum of cash at the same time. Your cash out refinance options come down to how much cash you want to receive and how long you’ll need to pay off your new mortgage.
For example, if you had $100,000 left on your existing mortgage and refinanced for $120,000, you could pay off your existing mortgage and receive $20,000 as part of your refinance deal. You could use those funds for just about any purpose, such as covering education expenses, medical bills, sprucing up your home, etc. With a cash-out mortgage, you can typically borrow up to 80% of your home’s equity.
Your equity is the current market value of your home (determined by an appraiser) minus any outstanding loans on it such as a mortgage, liens, or a home equity loan. If you owed $100,000 on your existing mortgage and your home’s current value is $300,000, then you would have $200,000 in equity.
A rate and term refinance is often less expensive with a lower interest rate than a cash-out mortgage because a cash-out mortgage involves more money and risk for your lender. Of course, either option would involve the same types of fees associated with any mortgage.
Fixed-Rate vs Adjustable-Rate Refinance Options
With a fixed-rate refinance, the interest on your loan remains the same. With an adjustable-rate mortgage (ARM) interest rate can fluctuate through the life of the loan. An ARM typically starts at a lower interest rate that’s in place for an introductory period of a few months to a few years. After that, it fluctuates based on activities in the financial markets. Some ARMs have limits on how much they can rise or fall over a given period.
Whether you choose a fixed-rate refinance or an ARM refinance is up to you, but keep in mind that interest rates and the housing market can be hard to predict. Some people choose an ARM to get a low introductory rate. They might expect that interest rates could fall, or they might sell their home or refinance again if the interest rate increases more than they expect.
Interest rates, the housing market, and your own income can change unexpectedly, so it’s important to consider how financially prepared you are for these uncertainties. When considering an ARM, calculate how much your rate might increase over a given time period, and whether you could still make your payments if that happens.
When Does Refinancing Make Sense?
Refinancing could make sense if you can reduce your interest payments, need to alter the terms of your loan, or would like to cash out on some of your equity. Just remember to include your fees and costs when considering your options.
Lowering Your Interest Rate
A refinance interest rate reduction is probably the most common reason that people refinance their mortgage, because it can reduce their borrowing costs. Some choose to refinance if they can reduce their rate by at least 2%, but for some homeowners, a 1% reduction is enough to make it worth their while. With the free financial calculators on our website, you can crunch the numbers and see how much you might save.
Changing Your Loan Term (Shorter/Longer)
If you started with a 30-year mortgage, refinancing with a 10-year mortgage would shorten your payback period and reduce your total interest costs. Of course, your monthly payments would probably increase, unless interest rates have dropped considerably from when you obtained your mortgage.
If you have a 10-year mortgage and would like to switch to a 30-year mortgage, it would probably reduce your monthly mortgage payments (depending on interest rates). Of course, a longer payback period would result in paying more interest over the long term.
Accessing Home Equity Via Cash-Out
People often choose a cash-out refinance when they have sufficient equity in their home and want to pay off their higher interest debts at a lower interest rate. Refinancing is especially popular in areas where property values have increased considerably, which increases your home’s equity, or when interest rates are lower than when they obtained their first mortgage.
Switching from an Adjustable-Rate to a Fixed-Rate Mortgage
For those who chose an ARM for a low introductory rate, some people refinance to switch from an ARM to a fixed-rate mortgage if they think interest rates are going to rise and they’re no longer within the fixed-rate introductory period.
To Eliminate FHA Mortgage Insurance
All mortgages backed by the Federal Housing Administration (FHA) require mortgage insurance premiums regardless of the size of the loan or your down payment. This is assessed as a premium that’s typically paid at closing, plus an annual premium that a borrower could pay or add it to their mortgage. By refinancing with a traditional mortgage, borrowers can eliminate that insurance requirement.
When Refinancing May Not Be the Right Move
There are two scenarios where refinancing your mortgage might not be a good option. It depends on how long you intend to stay in your home and how much time you have left to pay off your current mortgage.
When You Won’t Recover Your Closing Costs
Before opting for a mortgage refinancing, it’s important to estimate your “breakeven point,” which is how long you’ll have to make payments on a new mortgage before you start to save money. Closing costs on any mortgage typically range from 2% to 6% of the loan (sometimes more). Even if you could refinance at a lower interest rate, consider how long you intend to remain in the home and how long it would take your interest savings to offset the cost of refinancing. This is especially true if you add your closing costs to your new mortgage, rather than paying them out of pocket, because you’ll wind up paying interest on those closing costs.
When You’re Close to Paying off Your Existing Mortgage
Every mortgage payment covers a portion of your principal, which is how much you borrowed, and your interest costs. In the first few years of your mortgage, most of your monthly payment goes towards your interest costs. The farther along you are in paying off your mortgage, the more your payments reduce your principal. At the end of your payback period, most of your monthly payments are applied to your principal, and very little of it covers your interest costs. Take a look at your amortization schedule, which spells out how much of your payments are applied to interest and principal. If you refinance your mortgage, your amortization schedule would be reset. You would also reset the clock on how long you have to pay off your mortgage.
The Refinance Process at West Shore Bank
The mortgage refinance process is very similar to how you first obtained your mortgage. It starts with a credit check, where we examine your credit score and payment history, as well as any other loans you may have. You’ll need to gather paperwork, just like you did for your current mortgage. We’ll hire an appraiser to determine your home’s current market value.
Once we have all this information, we can tell you how much you’re eligible to borrow and what your options are. You make a decision, and we close on the loan. If it’s a simple refinance, we’ll pay off your existing mortgage, and you start making payments on your new mortgage. If it’s a cash-out refinance, your “cash out” funds will be deposited into one of your bank accounts.
Eligibility and Documentation Checklist
To make sure you have all the documentation you need to apply for a mortgage refinance, here’s a checklist of what we’re going to need:
• A government-issued photo ID.
• Your most recent pay stub
• W2s or 1099s from the past two years
• Tax returns from the past two years (if self-employed)
• Your most recent statement from the Social Security Administration
• Your most recent bank statement, to verify account balances
• Your most recent broker statement, if cashing in stock for a down payment
Tips to Maximize Your Savings
You’ll need to get your finances in order before refinancing your mortgage. Two of the biggest factors in determining your mortgage eligibility and your interest rate are your credit score and your debt-to-income ratio (DTI).
Improve Your Credit Score and Debt Ratio
You can check your credit score every week for free at AnnualCreditReport.com. If you see any inaccuracies, you can contact the bureau that lists the information and take steps to correct it. They are: Equifax, Experian, and TransUnion. A credit score of 620 or higher is typically required for mortgage refinancing.
Reduce Your Debts and Your DTI
Apart from your mortgage, paying down whatever other debts you have can help you improve your chances of obtaining a mortgage at a favorable rate, as this will improve your DTI. You can calculate your DTI by dividing your total monthly debt payments by your gross monthly income (before taxes and deductions). The lower your DTI, the better, and a DTI of 50% or less is typically required to refinance a mortgage.
Choose The Right Term and Rate Lock
One of the reasons we provide free financial calculators is so you can compare your options before deciding whether to refinance and the terms you’re looking for. A mortgage rate lock happens when we offer to refinance your mortgage at a particular interest rate, which is guaranteed for a certain period, such as the time it takes to complete the process.
Why Choose West Shore Bank for Your Refinance?
By working with a local lender, you can deal with someone who understands the local housing market from Western to northern Michigan and can help you compare your options. We make all our lending decisions locally, which allows for personalized service, fast approvals, and quicker closings. Refinancing a mortgage is as big a decision as when you first decided to buy a home, so why not deal with a lender who lives in works in the community and wants to help you succeed.
Next Steps – Apply for Your Refinance Quote
If you’re ready to take a closer look at refinancing your mortgage and would like to find out what you could be eligible for, please gather your paperwork and contact us or visit one of our locations in person. If you need additional mortgage planning tips and other financial advice, you can also check out our blog.
