When it comes to finance, it can feel like you need a PhD in economics before understanding any of it. From interest rates to refinancing—from Freddie Mac to her long-suffering beau Fannie Mae —this world is certainly complex. But if you get frustrated and don’t bother schooling yourself, you’re wasting real opportunities to save money on your home.
Our partner Better Cover has tapped their mortgage affiliate, Better Mortgage, to help us give you the lowdown on all things refinance.
Let’s say you pick up the Wall Street Journal’s real estate section and puzzle over a typical headline, something like: “With mortgage rates staying below 3%, homeowners looking to refinance have good options on the table.” What do mortgage rates even mean? And why, exactly, are they on that table in the first place?
In this article we’ll really break down the concept of refinancing so you can explain it to your colleagues at the water cooler tomorrow.
A quick mortgage refresher
If you have a mortgage, it means you took out a home loan to purchase your property. That loan came along with a long list of conditions for paying it off, including how much interest you have to pay.
That percentage of interest is usually based on how much of a down payment you made, or what type of loan you received. If you have a fixed rate loan, you have to pay back the loan to the lender over a fixed time period, at a fixed rate. In other words, if you secure a 4.5% interest rate over 30 years, you won’t be able to change the interest or term.
But if you got an Adjustable Rate Mortgage (ARM), your interest can fluctuate over the term of the loan. Not everyone likes taking an ARM because of its risky nature; to encourage borrowers, lenders of ARMs sometimes fix interest rates for the first couple of years. So let’s say you have an ARM for a 25-year mortgage. You might be offered a 3.5% interest rate for the first 5 years, after which the interest rate might fluctuate. You might find yourself paying 5% for the next 20 years… or 2.5%.
So what is refinancing?
Refinancing means replacing your existing mortgage with a brand new one. Which sounds kind of crazy when you think about it—after all, no store would allow you to replace a pair of shoes you’ve been wearing for 10 years and swap them for a new pair. But when it comes to your loan, it turns out that this is an option.
Why would you want to refinance? There’s a few common reasons:
- Take advantage of a lower interest rate and save money
- Shorten the term of your mortgage (i.e., pay it off quicker)
- Switch from a fixed rate loan to an Adjustable Rate Mortgage
- Use home equity funds for an emergency or large purchase
- Eliminate any Private Mortgage Insurance (PMI) you’re currently paying (provided you’ve paid 20% equity on your home)
If refinancing is so great, why isn’t everyone doing it?
The very simple answer? Not everyone knows about their options. You probably don’t sit in the bar nursing a G&T and chatting about the intricacies of refinancing your mortgage. And if the topic has come up, it’s likely that you’ve tuned out, assuming it’s more of a headache than it’s worth.
But just as Lemonade has transformed the old-school insurance industry, there are savvy startups doing the same for mortgages and refinancing. Case in point: Better Mortgage, which uses sophisticated technology to make the mortgage process easier and more transparent, all while cutting out extra fees.
“In today’s tech world, the mortgage process has become so much easier,” says Christian Volker, Director of Sales at Better. “It will become more commonplace for homeowners to use their home as a powerful tool for their personal financial needs.”
Things to consider before refinancing
Refinancing might not be the best financial fit for everyone. There are always things to keep in mind before taking the ReFi Plunge (which sounds like an HDTV reality show we’d definitely watch).
Your mortgage’s interest rate very simply means the cost to borrow money. Or to use financial jargon, it’s the percentage of the loan principal (ie. the original sum of money you borrowed) charged by your lender to borrow said money. The government leverages interest rates as a tool to control the economy and make sure the country is in good financial health.
Let’s say you have a 20-year mortgage and have $150,000 left on your ‘principal loan,’ with an interest rate of 4.5%.
You’ve noticed that current interest rates have dropped to 4%. If you refinance with the exact same loan, but an interest rate that’s 0.5% lower, you’d save $9,601 over the life of the loan. That’s a nice chunk of change, and money that could be applied to renovations, medical expenses, or college bills.
Here’s a checklist of points to ponder.
✓ Your break-even point
There’s a simple equation that can help you figure out if refinancing might be right for you. Better Mortgage calls it “finding your break-even point.”
To work out if refinancing is going to be beneficial for you, there’s a simple equation.
Divide the closing costs involved with your refinanced mortgage by your monthly savings to find out how long it will take to break even. So, let’s say your closing costs are $4,000 and you stand to save $100 each month in mortgage payments. In this scenario, it would take you a little more than 3 years to break even. Don’t like math? Use Better’s refinance calculator to work it out.
✓ Private Mortgage Insurance (PMI): Will you or won’t you?
If your down payment was less than 20% of the value of your home, you’re probably paying Private Mortgage Insurance (aka PMI). PMI protects lenders in case the borrower ends up unable to afford their mortgage payments.
On average, PMI premiums cost between 0.58% to 1.86% of the original loan amount per year. The good news is that oftentimes, you only need to pay PMI until you’ve reached 20% equity in your home. And if your home has increased in value, refinancing might mean you can stop paying PMI entirely, depending on your Loan to Value Ratio.
✓ Calculate your Loan-to-Value (LTV) ratio
Your loan-to-value (LTV) ratio is the percentage of a home’s value you’ll need to borrow after you’ve determined your down payment. If you put in a 20% down payment, your LTV is 80%; if you put down 10%, your LTV is 90%, and so on. Here’s the equation:
Loan amount ÷ appraised home value = LTV ratio
If you’re hoping to refinance your existing home loan, your application is more likely to be approved if your LTV is 80% or lower. The lower your LTV, the more likely you are to qualify for a lower interest rate.
✓ Mortgage term loan
Refinancing can also mean shortening your mortgage term loan without necessarily lowering your monthly payments.
Let’s say you have a 30-year fixed rate mortgage on a $100,000 home. Refinancing from an interest rate of 9% to 5.5% can cut the term in half to 15 years with only a slight change in the monthly payment. But if your interest rate is already at 5.5% over a 30-year loan ($568/month), switching to a 3.5% mortgage over 15 years would raise your monthly payment to $715. You’d want to calculate whether that’s something you could afford.
✓ Tapping into home equity
Refinancing to tap into your home equity is often called cash-out refinancing. This is when you refinance your home for a larger amount (often up to 80% of the home value), allowing you to take the difference in cash.
The closing costs for this type of loan can be rather high in some cases because you end up with less equity in your home than you had before. Be conservative in taking any money out of your home and be sure to leave yourself a healthy cushion in home equity.
You don’t have to do this alone
Refinancing is available to all homeowners, but that doesn’t mean all homeowners should be refinancing.
And it’s important to keep in mind that just because you want to refinance, it doesn’t mean a lender will accept your application. If you have a low credit score, have income issues, or don’t have enough equity—you might not be able to refinance.
If calculations leave you scratching your head, sit down with a lender who can break the process down for you. Or take advantage of a new wave of tech-focused companies which have streamlined the process in a way that’s accessible and stress-free.
The above has been a content partnership with Better Mortgage