3 Things to Know About Mortgage Refinancing

Homeowner seated at a glass table working on applying for a mortgage refinance.
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Mortgage refinancing is a popular and enticing option when interest rates drop as they've been doing in 2020. Refinancing involves taking out a new loan to pay off your existing one, at better terms and perhaps with a little extra cash to put in your pocket as well. The procedure is largely similar to what you went through to take out your existing loan.

Rates don't have to drop very far, either, before scores of homeowners decide that refinancing their home loans makes sense. It's possible to both increase the principal balance of a mortgage and lower the existing mortgage payment, and that's a major reason why many borrowers refinance.

But sometimes, and under some circumstances, refinancing can be the worst thing you can do.

A lower payment might not pay off in the long run. It's often a short-term resolution.

Refinancing Can Extend Mortgage Payments

It will probably take longer to pay your mortgage in full if you refinance. Let's say you took out a 30-year loan when you purchased your property, then you decide to refinance your loan at the end of five years. Now you'll be paying on that mortgage for a total of 35 years instead of looking forward to paying off your loan in 25 more years.

Your monthly payment would be $599.55 if your original loan was amortized for 30 years on a $100,000 balance at 6% interest. Your new payment would be $584.82 if you refinanced at 103,000 at 5.5% interest. Your loan will probably reset to a 30-year term because most borrowers select a 30-year amortization period.

You'll make an additional 60 months of payments in this scenario and you'll pay $35,065 more over the life of the loan, assuming you live in the property long enough to pay it off.

You'll lose $3,000 in equity, plus whatever principal balance you paid down on the original $100,000 loan if you decided to sell after refinancing.

Or It Can Shorten the Loan Term

Not all refinances are created equal, and some are intended to do the opposite and shorten your term. This would be the case if you refinance a 30-year mortgage into a 15-year loan.

The downside here is that your payments will almost certainly go up. The upside is that you'll be mortgage-free in a shorter period of time.

Refinancing to Reduce Payments

It's hardly worth it to refinance your mortgage to save $15 a month. Most experts say you should be able to recoup your costs from refinancing over a three-year period to make it worthwhile. It would take 200 months to break even if you've saved only $15 a month and refinancing cost you $3,000 in fees.

You would break even at the end of five years, however, if the total costs to refinance were $3,000 and you saved $50 a month on your mortgage payments by lowering it by that amount.

Some people turn into serial refinancers, rushing to refinance every time interest rates drop a half a point or a point, thinking they're doing the smart thing. In fact, it can be just the opposite when costs are added into the equation.

Refinancing to Take Cash Out

Another scenario involves refinancing when you've achieved some significant equity in your property, either thanks to the market or because you've paid down your original loan. For example, you could take $30,000 in cash if the fair market value of your property is $275,000, your existing mortgage balance is $245,000, and you refinance for $275,000, paying off that first loan and pocketing the difference.

You can do whatever you like with the "extra" money—fund your child's education or pay off high-interest debt—but it's still a loan, referred to as a cash-out refinance, and you must pay it back.

It used to be that you could claim an itemized tax deduction for the mortgage interest on such a refinance, but that changed with the Tax Cuts and Jobs Act in 2018. Now you can only claim a tax deduction for the interest if you use the money to build another property or to substantially improve your existing home.

A Streamline Refinance

The FHA offers streamline refinances if your existing mortgage is already FHA-insured and you're current with payments. You can't take cash out with this option, at least not for more than $500, but the paperwork involved and underwriting requirements are significantly reduced. There will still be costs, however.

Costs Associated With Refinancing

You'll either pay for the costs of mortgage refinancing through a higher interest rate, or those fees will be added to your unpaid balance because few homeowners pay those costs in cash, but you will pay them. There's no free ride.

Typical fees paid to obtain a refinance include:

  • Appraisal
  • Title policy
  • Escrow
  • Loan points
  • Origination
  • Processing
  • Underwriting
  • Wire
  • Beneficiary demand
  • Application
  • Administration
  • Reconveyance
  • Credit report
  • Notary
  • E-mail doc
  • Tax service
  • Recording

The costs associated with mortgage refinancing are generally rolled into the loan. They're added to the existing balance, increasing the loan amount. And an owner's equity is decreased when a loan amount is increased.

Credit Considerations

Loan approval isn't guaranteed for any refinance, although that might seem counterintuitive because you're already paying a mortgage and basically all you're doing is replacing it with another. Your creditworthiness will still be a factor nonetheless.

Most lenders will compare your current credit score to what it was at the time you took out your original mortgage. You could be denied if it's dropped considerably. At the very least, this could affect your interest rate.

Should You Refinance?

Everyone's situation is somewhat unique, and refinancing might make sense for you when it wouldn't necessarily be a good deal for others. Ask a real estate professional such as an appraiser, an escrow officer, or even a real estate agent to compute the math for you if you're in doubt.

Don't ask a mortgage lender. The answer will most likely be yes because they have something to gain.

Article Sources

  1. Federal Reserve Board. "A Consumer's Guide to Mortgage Refinancing." Accessed March 22, 2020.

  2. Debt.org. "Mortgage Re-Fi." Accessed March 22, 2020.

  3. Tax Foundation. "The Home Mortgage Interest Deduction." Accessed March 22, 2020.

  4. HUD.gov. "Streamline Your FHA Mortgage." Accessed March 22, 2020.

  5. Central Bank. "The Pros and Cons of Refinancing." Accessed March 22, 2020.