Refinancing a home loan refers to the process wherein homeowners replace their existing mortgage with a new one, typically to secure a lower interest rate and reduce monthly payments. Although this method helps them save significantly, refinancing can be tricky, especially for those who are unfamiliar with the process. Potential homeowners should assess various factors, including their credit score, the amount of home equity, and current market conditions, before opting to refinance their home loan.
Key things to consider before opting for refinancing a home loan
1. Credit score
This is a crucial factor that determines a homeowner’s eligibility for a refinance and the interest rates that they can avail themselves of. Typically, homeowners are expected to have a minimum credit score of 620 to be eligible for conventional home loan refinancing. But it is important to note that some government-backed programs, like FHA loans, allow refinancing for homeowners with lower credit scores. Since a high credit score improves homeowners’ chances of getting favorable rates and terms, they should take the necessary steps to improve their credit history.
2. Home equity
Lenders often look to see if homeowners have ample equity in their homes to qualify for refinancing. Homeowners can find out their home equity by evaluating the difference between the market value of their home and outstanding mortgage balances, if any. Typically, borrowers are expected to maintain at least 20% home equity to qualify for better rates and terms and avoid private mortgage insurance.
3. Closing costs
When opting to refinance a home loan, homeowners should be wary of closing costs, which may typically range from 3% to 6% of the entire loan amount. These costs include appraisal fees, credit report fees, attorney fees, and title search fees.
4. Existing interest rates
Since interest rates tend to vary depending on market situations, refinancing will only benefit a homeowner if the new interest rate offered is lower than the current one. Refinancing is advised if an individual can reduce their interest rates by around 2%.
Advantages of refinancing a home loan
1. Lowering interest rates
One of the key reasons why homeowners opt to refinance a home loan is to avail themselves of a new loan with a better interest rate. While refinancing makes sense if an individual can lower the interest rate by at least 2% with their new loan, many lenders suggest that even a 1% reduction can make a major difference in overall savings and monthly payouts. Individuals opting to refinance their home loan can use a mortgage calculator to understand the exact amount they will save.
2. Shortening the loan term
Homeowners opting to refinance their loan can consider exploring alternatives that reduce the term of their mortgage. This allows them to settle their debts faster. Besides, it also contributes to significant savings on interest over time. For example, if homeowners opt to refinance their existing 30-year mortgage into a 15-year loan, their monthly payouts will increase, but they can save big on interest by paying off the loan quickly.
3. Switching loan types
Many homeowners consider refinancing their home loan to switch from a fixed-rate mortgage (FRM) to an adjustable-rate mortgage (ARM) or vice versa. While ARMs are mortgage loans whose interest rates change periodically depending on fluctuating market conditions, with FRMs, the interest rates don’t change throughout the loan term. While ARMs often start with lower interest rates, which may rise with time and add to expenses, converting to FRMs will help homeowners avoid interest rate hikes in the future.
Moreover, switching from FRM to a new ARM can be advantageous if homeowners don’t plan to live in the house for many years.
4. Consolidating debts
Homeowners can also consolidate their high-interest debts and tap into the equity accumulated in their house when opting for home loan refinancing. One avenue that allows for this is cash-out financing, wherein a homeowner takes out a loan that is larger than their existing mortgage, pays off the old mortgage, and utilizes the remaining funds for purposes like settling credit card debts or remodeling their homes. It is important to note that this method will increase their mortgage balance and lead to additional interest.
When to avoid opting for refinancing home loans
While refinancing can be advantageous in many scenarios, there will be instances when it may not be the best financial decision.
- Avoid using refinance savings or cash-out proceeds on one-time expenses like vacations or cars. It’s generally better to save on such costs.
- If homeowners are more than halfway through the loan term, refinancing may not help save money. At this point, most payments are going toward the principal, and refinancing resets the loan term, increasing interest payments.
- Paying off the loan early is not advised if it affects key financial goals like creating an emergency fund or retirement savings.
- If homeowners’ credit score or debt-to-income ratio has worsened since the original loan, they will be offered a higher interest rate on refinancing, which will raise the overall cost.
- Refinancing is not a wise option if an individual plans to sell their current home in a few years. Since it can take years for homeowners to recover the costs associated with refinancing, it might not allow them to save much before selling the property.