Refinance 101
Jan 30, 2024 | General | Share:
Although mortgage rates are constantly fluctuating, homebuyers have enjoyed historically low interest rates over the past several years. In fact, interest rates in 2021 dropped as low as 2.6%. But to combat inflation, mortgage interest rates began to rise in mid-2022 and reached a 20-year high near the end of 2023.
While we may never return to the days of 2-3% interest rates, they have begun to fall in 2024. Experts forecast that mortgage rates may continue to drop this year. Individuals may want to take advantage of these lower interest rates and refinance their home loans.
Because it’s been a few years since interest rates have been favorable for a refinance, we’ve put together a guide to refinancing your mortgage. Whether you’re a homeowner or an agent looking to help your clients, check out our guide to refinancing a home loan.
What is a refinance?
When you refinance a mortgage, you replace your original loan agreement with a new one. This allows a borrower to start fresh with their mortgage and make changes to their lender, interest rates, payment schedules, loan terms, or any other terms outlined in their previous mortgage agreement.
Borrowers can shop around and compare rates and terms from several lenders to find the best deal or a mortgage that best suits their current refinancing needs. Borrowers commonly refinance their home loans when interest rates are lower or their credit situation is improved.
When should a homeowner consider refinancing?
Homeowners usually consider refinancing their mortgage for one of the following reasons:
- Lower their interest rates
- Change the loan type
- Change the loan term
- Cash-out refinance
Lower Interest Rates
Many borrowers refinance their mortgage to take advantage of lower interest rates. Because your monthly mortgage payment is comprised of both principal and interest, a refinance with lower interest rates will also lower your monthly payments. It will also reduce the amount of total interest you pay over the life of your loan.
If an individual purchased their home in late 2023 with a $300,000 mortgage loan and an interest rate of 7.8% and chooses to refinance their loan at 6.5%, they can save around $250 a month on their monthly payment. This can save them nearly $90,000 in interest payments over the life of the loan.
Change the Loan Type
Another popular reason to refinance is to change the loan type you have. With an adjustable-rate mortgage (ARM), the interest rate that’s applied to the remaining balance changes over the life of the loan. As a result, monthly payments can go up and down. Individuals with an ARM may want to enter into a fixed-term mortgage as interest rates decline to secure a lower, predictable interest rate.
You may also be able to refinance to eliminate private mortgage insurance (PMI). Lenders typically require PMI when the down payment is less than 20% of the home’s value. If your home’s value has increased significantly or you’ve paid down your mortgage, a refinance may be worth considering.
Change the Loan Term
You can also change the length of the loan term when you refinance. You can shorten or lengthen the loan term, impacting the monthly repayments. If you decide to shorten your loan term, you’re looking at larger monthly payments; in return, you will save with lower lifetime interest costs and will pay off your mortgage sooner. If you lengthen your loan term, you will lower your monthly payments but pay more in interest over the life of the loan.
Cash-out Refinance
In a cash-out refinance, you take out a new mortgage for more than you owe on your current mortgage and receive the difference in cash. This is different from a standard refinance where you simply adjust the terms of your existing mortgage without taking additional cash out. Cash-out refinances are often used by homeowners to consolidate debt, make home improvements, or finance large purchases by tapping into the equity they have built up in their home.
Every borrower has a different set of circumstances and should consider closing costs, appraisal fees, and potential penalties when deciding to refinance.
When is it a good idea to refinance?
Everyone has a different financial story, so only you can decide if it’s a good time to refinance. Before refinancing a mortgage, it’s important to consider:
- Closing Costs
- Break-Even Point
- Impact on your Credit Score
- Potential Tax Implications
Closing Costs
When you refinance, you are responsible for covering all your closing costs. They are usually 2%-6% of your loan’s total value. If you refinance a $200,000 loan, you must have $4000 - $12,000 in cash at closing. Many lenders will allow you to roll these closing costs into your new loan payments, but this will result in a higher monthly payment. Your lender can answer specific questions about your loan's closing costs.
Break-Even Point
To evaluate your break-even point, you need to calculate how long it would take to recoup your closing costs for the refinance. If your closing costs are $6000 and you will save $200 on your monthly payments, it will take 30 months to recoup those closing costs. In this case, refinancing makes sense if you plan on staying in the home for at least 30 months.
Dawn Braddock, COO of South Oak Title and Closing in Birmingham says, “If you’re planning to stay in your home for five years or more, a ¾% drop in interest rates means a refinance may be worthwhile. For others, look to refinance if the interest rates drop 1% or more.”
Impact on Your Credit Score
A refinance can have both positive and negative effects on your credit score. Most negative effects are only temporary and minor; however, borrowers should be aware that their credit score will usually be initially lower after refinancing their home.
A refinance also has the potential to positively impact your credit. Lower monthly payments can make it easier for borrowers to make consistent, on-time payments, which is always beneficial for your credit. If you use your refinance to obtain cash to consolidate or pay off existing debts, this will also improve your credit score.
Potential Tax Implications
A refinance can have an impact on your tax liabilities. Mortgage interest paid is considered tax deductible; however, a refinance will change the amount of interest you’re paying toward your loan. Cash-out refinances have particular tax implications. To be eligible for the tax deduction, you must use the cash to purchase, build, or improve your home. Because tax liabilities vary among individuals, it’s important to consult a tax professional if you have questions about how your refinance will impact your taxable income.
How do you close a refinance?
Closing is the final stage in refinancing your home loan. Closing a refinance is very similar to closing a home purchase. By scheduling your closing with a reputable title and closing company, you can be sure to have a simple, straightforward closing experience for your refinance.
Your lender and the closing company will let you know who needs to be present at closing, and what documents you need to bring. At closing, you review and finalize the terms of your mortgage agreement and sign all necessary paperwork. After closing is complete, the title company will record your new mortgage in your county.
If you’re considering a refinance, be sure to partner with a title and closing company you can trust. At South Oak Title and Closing, we’re dedicated to helping our clients have an outstanding closing experience, whether they’re closing on a new home or refinancing their existing home. To schedule a closing for your refinance, contact us today.