Owning a home is a huge part of the American Dream, and for most Americans, this purchase will likely be one of their biggest investments. Traditionally, homeowners would make monthly payments over the lifetime of the mortgage, then they would sell the property or purchase a reverse mortgage to fund any outstanding or necessary expenses during retirement.
However, now that interest rates are so low, refinancing a home is quickly becoming a popular and common way to tap into equity at various points during the lifetime of a mortgage loan.
Refinancing a home is a smart decision for a variety of reasons:
• You can tap into equity to pay off high interest credit card debt.
• You can use the money to make improvements to your home, send a child to college, invest in a small business, or purchase income property.
• You can lower your interest rate, saving thousands of dollars over the lifetime of the mortgage.
• You can capitalize on increased equity to get rid of high interest private mortgage insurance (PMI).
• You’d like to change the terms of the loan from adjustable to a fixed rate, or from 30 years to 15.
But is refinancing a home the right decision for you? Before you look further into the process, here are some things you should know.
Home Equity 101
When you buy a house, you finance most of the purchase price through a mortgage loan. At a typical closing, the amount of equity you have is equal to the amount of the down payment you made. That is, if you put 10 percent down on a $300,000 house, you have 10 percent equity, or $30,000. The rest of the house belongs to the lender.
Over time, you build equity in two ways. One is through a decrease in the principal that occurs as you make regular payments on your loan. The other is through increases in the market value.
For instance, in five years, you will have paid down the principal on a $270,000 loan (at 4 percent interest) to a little under $240,000. At the same time, suppose the market value of your home has risen to $340,000. You now have $100,000, or roughly 30 percent, in equity.
What Does the Refinancing Process Entail?
When you refinance, you go through the borrowing process all over again — even if you use the same lender. Before you can be approved, the lender runs a credit check and requests documentation of your work history and existing debt-to-income ratio. Then you lock in a rate for 30 days. In preparation for closing, you will need to have an appraisal done, and depending on the amount of time since your first loan origination, you may also need to repeat the title work.
In total, you can expect to pay 2 to 7 percent of the loan value on the refinance. Most lenders will roll this fee back into the loan, eliminating the need to pay cash at closing.
When Is Refinancing Worthwhile?
• You’ve improved your financial situation.
Although it’s possible to refinance with a less than optimal score, you are only likely to qualify for a lower interest rate with very good to excellent credit. Whether the new interest rate is low enough to make refinancing a good deal depends on a variety of factors, including how long you plan to live in the house and how much the refinance costs. Always use a mortgage calculator to figure out how much you will save with the new rate so that you know for sure.
• You can lower your monthly payment.
Lowering your mortgage payment frees you to pay down debt and save money for long term purchases. If, at the same time, the lower payment allows you to pay less interest on the loan principal over time, refinancing is an investment that makes good financial sense.
• You have enough equity to fund needed purchases.
You can refinance to a lower rate at any point during the loan history. However if you want to qualify for a home equity loan or home equity line of credit (HELOC), or you are looking to get rid of your PMI, you must have over 20 percent equity in the home.
You also need to consider the wisdom of borrowing against your equity. Using it to pay off other debt only makes good financial sense if you are going to adopt habits of better financial discipline in the future. If you simply incur more revolving debt once you cash out your mortgage, you will be in a worse position financially, especially if the mortgage payments on the new loan are higher than the original payments.
Ultimately, improving your short- and long-term financial situations should be the goal of refinancing your home. It can be a great tool for building wealth. Done irresponsibly, however, refinancing can simply lead to more debt.
About Peak Finance Company
Peak Finance Company is a mortgage banker and broker that specializes in solutions-based lending, currently operating in California, Oregon, and Georgia. The company prides itself on offering a personalized and creative approach to the mortgage-lending process, one that makes it possible to offer loans to individuals in a wide variety of circumstances and at the most competitive rates.