Refinancing Your Mortgage: When It Makes Sense
Key considerations for when refinancing is a good financial move.
Refinancing your mortgage can offer a way to take advantage of low interest rates -- or, if your mortgage payments have become oppressive, an escape from adjusting rates, increased payments, or reduced income. With property values falling and companies tightening their belts or even laying off employees, there's no better time to make sure your mortgage meets your current budget and long-term needs.
What Is Refinancing?
When you refinance, you get a new mortgage to replace your existing mortgage. Because you're getting a brand new loan, you usually have to pay title insurance and escrow fees, lender fees, points (optional), appraisal fees, credit reporting fees, and any amounts needed to bring your insurance and tax obligations up to date.
Homeowners refinance for many different reasons, but here are some of the common ones.
Refinancing can save money by lowering your interest rate. If the interest rate on your current mortgage is higher than the current market rate, you'll pay less by refinancing.
Refinancing allows you to change loan types. For example, if you have an adjustable rate mortgage, your monthly payment may increase when the rate adjusts. You might want to switch to a fixed rate mortgage, which has a stable payment. (For more information on loan types, read Nolo's article Fixed Rate vs. Adjustable Rate Mortgages.)
Refinancing can lower monthly payments. Even if your interest rate doesn't decrease, a refinance can lower your monthly payments by starting a new loan term. For example, if you took out a 30-year, fixed-rate mortgage for $300,000 ten years ago, you may only owe about $250,000 now. But if you refinance into another 30-year, fixed-rate mortgage for $250,000, you'd have a full 30 years to pay it off, which means each monthly payment will be smaller. (Had you kept your old loan, you'd finish paying it off in 20 years.) The downside of lowering your monthly payments is that you'll pay more interest overall.
Refinancing can help you get cash. With a "cash-out" refinance, you take out a new mortgage for more than you owe on your current mortgage, then walk away with the difference. A cash-out refinance is very hard to get these days, although many homeowners did cash-out refinances to finance home improvements in the past few years. (An alternative that's usually cheaper overall, but requires you to make higher monthly payments, is a home equity loan or home equity line of credit). To do a cash-out refinance, you need significant equity in your home, because the bank probably won't lend you more than the house is worth.
Who Can Refinance?
If you have sufficient equity, you can refinance. A new lender will consider the same factors your original lender did: your income, debt-to-income ratio (how much of your monthly income is spent paying off debts other than the mortgage), your home's value, how much equity you have in your home, and your credit score. If your income has been reduced since you purchased, your home's value has plummeted, you've assumed a lot of new debt, or your credit score has gone down, you may find it difficult to refinance, or you'll at least pay more to do so. (You wouldn't be the first person to get turned down on a refinance despite living in and successfully paying the monthly mortgage on a home.)
The lender will likely require you to have the house appraised. The purpose of the appraisal is to make sure that the value of your home is greater than the loan amount. If you default on the loan and the lender forecloses, it wants to know it can sell your house for more than the existing loan balance.
Special Challenges in a Tightened Mortgage Market
Refinancing is much harder than it once was, for a few reasons. Some borrowers have difficulty refinancing because they have insufficient equity, mostly because the value of their property has not returned to an amount that exceeds what they owe on the mortgage. And lenders have become surprisingly strict about how much they'll lend, usually requiring refinancing homeowners to have at least 5-10% equity in the home.
Another problem is that lenders have made "stated income" loans all but unavailable. With stated income loans, borrowers didn't have to provide independent verification of their income. Instead, the amount they could borrow was based on the income they claimed to have (hence their nickname, "liar loans"). These were intended for people who had a hard time verifying income, such as the self-employed. But in the real estate bubble of the early 2000s, borrowers used stated income loans to artificially inflate their income to qualify for bigger mortgages. Unless their income or equity have increased substantially, borrowers currently holding this type of loan will have a hard time qualifying for more traditional refinance mortgages for similar amounts.
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