If you are among the 202,000,000 Americans that own a home1, you’re likely familiar with the caveats of the “American Dream”. Among the most popular is the infamous mortgage.
While the average U.S. mortgage debt per borrower in 2019 was around $202,000, each state makes a different contribution to this statistic. California, for example, maintains an average mortgage balance of $364,000 while North Carolina only clocks in at $162,0002.
The total average mortgage loan debt is rising however, averaging $184,000 in 2015 to $202,000 in 2019 nationally. With more and more money on the line, it’s easy to see why people may want to jump at any opportunity to lower their payment or access equity. But before diving in, there are important things to consider before refinancing your mortgage.
What Is A Mortgage Refinance?
Bankrate.com defines a refinance as “the process by which one loan is replaced by another loan, in most cases with more favorable terms.3” Thus, a mortgage refinance is the strategy of replacing a less favorable home loan with something better suited for your situation. Often this happens as a result of lower interest rates, but there can be other reasons as well.
5 Reasons You May Consider Refinancing Your Mortgage?
There are many reasons you may want to refinance your mortgage. Reducing the interest rate, removing PMI, reducing monthly payments, consolidating debt, and accessing equity are among the most common reasons.
These reasons have been listed for your reference and shouldn’t be taken as a recommendation. Just because you can refinance your home to consolidate debt, for example, doesn’t mean that you should. Run these scenarios by your financial planner to see whether a refinance is in your best interest.
Reason #1: To Lower Your Interest Rate
The average mortgage interest rate in 2008 was 6.03%, falling to 4.54% ten years later in 20184. While this may not seem like a dramatic change, it is. The graphic below shows the estimated financial impact made on a mortgage balance of $200k, $350k, and $500k in year 1:
These savings can be significant stretched out over a 30-year period. While the positive impact to your long-term net worth is evident, immediate gratification is obtained in the lower monthly payment. For example, a $350,000 30-year mortgage will have a principal and interest monthly payment of $2,105 at 6.03%, whereas a rate of 4.54% will only require a monthly payment of $1,782. This monthly difference of $323 can have a material impact on your quality of life.
Reason #2: To Remove PMI (Private Mortgage Insurance)
According to the Consumer Financial Protection Bureau, “PMI is usually required when you have a conventional loan and make a down payment of less than 20 percent of the home's purchase price. If you're refinancing with a conventional loan and your equity is less than 20 percent of the value of your home, PMI is also usually required.”
Some lenders provide a provision that allows you to appreciate out of your PMI requirement; that is, if your home value appreciates beyond the 20% equity threshold you may be able to request that it be removed.
While this benefit applies to some, it does not apply to all. Instead, lenders often require a refinance to ensure the purchase price (or refinance value) is reflective of the higher valuation.
Reason #3: Reduce Monthly Payments
As already discussed, reducing the interest rate applicable to your loan is a great way to reduce the monthly payments. There are two additional ways to reduce your monthly payment.
The first is to stretch the loan out for a longer period. Even without a change of interest rates, your monthly payment would be reduced given that the loan will be paid over a much longer period (though your total payments will be more at the end).
The second is under the assumption you refinance your loan while making a subsequent down-payment against the balance. Even without a change of interest rates or duration of the loan, a down-payment will offset the total balance that needs to be paid over the length of the loan.
Reason #4: Consolidate Debt
When mortgage rates and repayment periods are favorable, it can be easy to consider the possibility of consolidating other debt into your refinanced mortgage.
This can be done by using your home equity to pay off other loans, such as credit cards, personal loans, or even school loans. For example, if you have a $200,000 home value and owe $130,000 on the mortgage balance, you could use around $30,000 of the equity to address other outstanding loans. This assumes you refinance with a new mortgage of $160,000, leaving you with 20% equity to avoid PMI costs.
The primary method to accomplish this strategy is to use a “cash-out refinance” as described below. As previously mentioned, run your scenario by a trusted financial planner to ensure this approach yields more benefit than it does risk.
Reason #5: Access Equity
Accessing equity in your home via refinance is also referred to as a “cash-out refinance.” This applies when the home value has either increased substantially, or the mortgage has been paid down to the point where your equity in the home is more than 20%.
Often this is done to access cash needed to pay off other debt, pay for new home improvements, or to address other financial needs.
6 Costs To Consider Before Refinancing Your Mortgage
Below are six of the most common costs associated with refinancing a mortgage. Each should be considered in detail, as the collective sum of costs must be outweighed by the collective benefits to ensure a mortgage refinance works to your advantage.
Cost #1: Application & Underwriter Fees
Many lenders will require you to pay an application fee to help cover the costs of beginning the loan process. This fee will vary from one lender to the next, as will the stipulations. Some lenders, for example, will return the fee to the borrower once the loan process is completed. Others may apply it to the final closing costs.
While the fees differ depending on the lender in question, it can get as high as $500.5
Cost #2: Appraisal Fees
Often a lender will require a new appraisal of your home to help justify the amount of the new mortgage. While you likely had your home appraised when you applied for the original mortgage, changes in the market, economic cycle, and geographic area have all contributed to a potential change in the home value. The property appraisal cost can vary, but the average lands at about $480 for a typical, single-family home.6
Recently my wife and I explored refinancing our home given the lower interest rate environment. After further review it didn’t make much sense financially. This was, in small part, due to the $700 appraisal cost that was required. Our lender had a “preferred” appraisal company we were required to use. Blasphemy!
If you currently have an FHA mortgage and are looking to refinance with the government’s streamlined FHA refinance mortgage, you may not be required to have your home reappraised.7
Cost #3: Title Insurance
Title insurance is required by any mortgage lender to have, as it helps dissipate any ownership disputes on the property during the term of the loan. While you may have purchased a policy when obtaining your original mortgage, a new policy is required when refinancing your mortgage.
LendingTree reports that the average cost of title insurance is around $1,000.8 The location, and thus loan size of your property, is among the biggest factors that determines this cost. The higher the loan, the higher the risk. The higher the risk, the higher the cost of title insurance.
Cost #4: Credit Check
To ensure the lender is charging you the appropriate interest relative to the risk they’re taking, it’s a priority for them to check your credit score before lending you money. Obtaining one’s credit score, however, comes at both a monetary and non-monetary cost.
By way of fees, you can expect to pay anywhere between $30 to $100 for the lender to obtain your credit score.
All costs don’t always come with dollar sign, however. Requesting that a lender check your credit can have a material impact on your credit score. This is due to what is called a “hard inquiry,” a type of credit check that causes your score to drip slightly. As you pay off your new loan over time, all other things constant, you will likely see your score improve as a result of the payment history.
Cost #5: Taxes
Depending on where you live, some local or state governments require you to pay taxes relevant to refinancing a mortgage. These could include mortgage tax, realty transfer tax, mortgage recording fees and more. As you work to account for all the costs associated with refinancing your mortgage, make sure you check in with your local tax laws and codes to see what taxes you may be required to pay at closing.
Cost #6: Closing Costs
Closing costs will vary greatly depending on each homeowner's unique circumstances, location, and the amount being borrowed.
Closing costs may incorporate some of the fees mentioned above and may also include items such as a processing fee, document preparation, and attorney fees. Another item typically accounted for in the closing cost is escrowed taxes and homeowner’s insurance - which vary depending on your location.
In summary, you can expect to pay between 2% - 4% of the loan amount towards closing costs after taking everything into consideration.
Is Refinancing Your Mortgage Worth It?
Deciding to refinance your mortgage may seem like a no-brainer if you’re considering debt consolidation, reducing your monthly payments, or taking advantage of lower interest rates. Unfortunately, it’s not so simple as the costs can quickly eat away at the perceived benefits. One of the biggest factors of cost over benefit is dependent on your anticipated stay in the house. Specifically, how long do you expect to live there?
Let’s consider taking advantage of lower interest rates for example. We assume you have a rate of 5.25% on your $300,000 loan and are considering a refinanced mortgage at 4.5%. All things equal, you would save $2,250 of interest in the first year. The cost of refinancing, assuming 3%, would be around $9,000.
Sticking to simple math, it would take exactly 4 years before you broke even on the cost/benefit of refinancing ($9,000 / $2,250). If you’re planning on living in your home for the next 10, 20, 30+ years, it could be more than enough time. But if you’re planning on moving anytime soon, perhaps not.
It’s hard to resist the temptation of refinancing your mortgage, especially if the rates drop or you want to get out of your PMI payments. But before you start the paperwork, be sure to consider all the costs you’ll be expected to pay towards refinancing your mortgage.
This article was written by Jeffrey Stewart, CFP®, CRPC® on behalf of Lucid Wealth Planning LLC. Please contact Jeffrey if you have additional questions or would like to review your situation in more detail.
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