Considering a Mortgage Refinance? 

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Matt Soladay

Matt Soladay

Mortgage interest rates are the lowest they have been since Freddie Mac began recording them in 1971. This makes borrowing money cheaper than in the past, so the mortgage refinance industry has been very busy.  As of July 2020, the rate on a 30-year fixed mortgage was 3.02%. Like many, Laura and I began exploring our refinancing options.

Refinancing is the process of a bank or lender offering you different terms for your mortgage than you currently have.  The banks always make money from this process, but we are more concerned about whether a refinance is good for us, the borrower. Most people refinance their mortgage for a lower interest rate, paired with a smaller monthly payment.  This is a pretty easy ‘sell’ by the banks because who wouldn’t want that?! On the surface, it looks pretty good.

Laura and I bought our first home three years ago and took out a 30-year fixed mortgage at 4.25%. In the last few months, I got a call from our original loan officer for our mortgage, who said, “I can save you guys a lot of money!” Obviously, I was intrigued.  Now, I must admit that I like this person because he is knowledgeable, easy to talk to, and easy to get a hold of, the perfect combination for a good salesman when you think about it. Although it’s true that we could be saving a lot of money, that’s not always the case because there are many factors to consider.  So, before I share what we learned, here are the most common reasons to refinance. 

The Most Common Reasons To Refinance

  1. Lower your interest rate
  2. Reduce your mortgage term.
  3. Lower your monthly payments.

The perfect mortgage refinance involves getting all of these three things, but the only way that is really achievable is by coming to the table with a boatload of cash.  This is why it is essential to focus on your priorities and future goals during the refinancing of what is likely, the largest loan of your life.  Let’s look at the impact of interest rate first. 

Lower Your Interest Rate

Mortgage interest rates change based on the country’s broad economic outlook and fluctuate daily based on a variety of factors outside your control.  However, the two biggest factors within your control that will influence the interest rate you are offered are:

  1. Your Credit Score
  2. Loan to Value Ratio

For lenders, it comes down to risk.  How risky is the loan they are considering offering you?  And, how likely are you to pay them back?  The better your credit score is, the less risky a bank will see you as a borrower and, thus, offer a better interest rate compared to having a bad credit score.  The same goes when a bank looks at how much you borrow vs. the home’s actual value.  For instance, if your home is worth $200,000 and you borrow $190,000, your loan to value ratio is 95%.  The higher that number is, the riskier the loan is.  Also, a high ratio will likely require PMI (Private Mortgage Insurance) to be paid every month until your loan to value ratio is less than 80%.  

In addition, your overall financial circumstance plays a role as well.  Do you have regular employment?  Do you have large amounts of other debts or high fixed costs?  The healthier you look on paper to the bank, the better the interest rate they may be willing to offer. 

There will be many lenders willing to provide you with a loan, but remember that you have options, so shop around to get initial interest rate quotes from more than one lender.  You give yourself a chance to get a better rate, but you may just get a much better customer service experience as well.  Just be mindful of how many applications you submit and credit checks that occur because it could negatively impact your credit score and, ultimately, make it more challenging to refinance.

Reduce Your Mortgage Term

The two most common mortgage term lengths are 15-year and 30-year.  The biggest benefit of refinancing to a 15-year is the drastic change in term length and interest paid over the loan’s life. However, that means your monthly payment will be noticeably higher.  For example, if you were refinancing a $300,000 loan at 3.5% on a 30-year term, your monthly payment would be $1,347.  If you chose a 15-year term instead, your monthly payment would be $2,144.  That is a difference of $800 a month.  If your income has steadily increased over the years or you have more flexibility in your budget, reducing your term will allow you to be mortgage-free sooner.

Lower Your Monthly Payments

The monthly payment tends to be the factor that catches most people’s attention when considering a refinance because it’s natural to want as low of a monthly payment as possible. The less you spend on your mortgage payment, the more room you have for spending and saving elsewhere.  Sounds awesome, but the perceived value of refinancing to get lower monthly payments could actually reduce the financial benefit if you are extending the loan length, which could result in years of additional mortgage payments

Our Decision to Refinance 

For Laura and me, the priority with a refinance was to save money without increasing our monthly payment. We were three years into a 30-year fixed-rate mortgage at 4.25%.  That means we had 27 years of mortgage payments left if we chose not to refinance.  Understanding this was the key to properly evaluating the offers we received.

OFFER #1:  a new 30-year fixed at 3.375% with closing costs and fees of 3% of the balance rolled into the new mortgage, so no money due at closing.  Our monthly payment would go down $250, and we would save $17,699 over the life of our loan.  Those are positive things, but spending less money was the goal, and only saving $17,699 while extending the length of our mortgage was not worth it for us.  So, we declined this offer.  The follow-up offer included a term length we never considered.

OFFER #2:  a new 25-year fixed at 3.25% with closing costs and fees of 3% of the balance rolled into the new mortgage, so no money due at closing.  Our monthly payment would go down by about $50, but we would save $71,095 over the life of our loan.  Now we’re talking!  This offer was the perfect balance of a lower interest rate paired with a shorter-term length resulting in maximum savings without increasing our monthly housing payment.  In addition, the total principal balance will decrease faster, which means the amount of equity we have in our home will increase faster.

The first offer’s key weakness was three extra years of mortgage payments, which ate away at the potential benefit of a lower monthly payment.  Many people don’t fully appreciate that, and they accept an offer like the first one, missing out on tens of thousands of dollars over the life of their loan.  We avoided this by reducing the length of our mortgage.  We didn’t entertain shorter terms than 25 years because we wanted to control our fixed costs, and we did not want our monthly payment to increase.

The key to mortgage refinances is that the amount of money you save is significantly more than the refinance cost.  Comparing your net savings is essential when considering different offers.  Also, it’s worth noting that it usually takes two to three years to reach the break-even point,’ which is the length of time it takes to recoup the refinance costs, something to keep in mind depending on how long you plan to stay in your home.

Refinancing may or may not be the right decision for you.  So, shop for lenders, do your research, and weigh your options based on your current financial situation and goals. If you do decide to refinance, the savings could help improve your overall financial situation. 

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