Most homeowners refinance either to get a lower interest rate that will reduce the cost of their mortgage or to convert a portion of their equity into cash. Many owners may not be aware of additional reasons to refinance that may add to the benefits that refinancing makes possible.
Owners who recently purchased a home or refinanced when rates were low are unlikely to refinance again in the next few years. In 2022, the Federal Reserve announced it will gradually increase rates to combat inflation.
When you refinance, you trade your current interest rate for a new rate when you take out your new loan. Switching from lower to higher rates will deter most owners from refinancing soon.
Furthermore, refinancing isn’t free. At closing, borrowers pay the costs the lender incurs to make the loan, such as appraisal, recording fee, lender title, settlement service, and land survey. In 2020, the average closing costs to refinance was $3,398, including taxes, which can vary by state. Even so, a need for cash in a medical emergency or paying tuition to avoid student loan debt might be good reasons to refinance despite higher interest costs from a new loan. Here are six lesser-known reasons to refinance…
1. Convert equity into cash
Cashing out some equity is the most popular reason for refinancing. Equity is the difference between a home’s value and the amount owed on a mortgage. It is the “profit” that owners accumulate over time as they pay off their mortgage and their home appreciates. Equity is how most families build legacy wealth to pass to the next generation; it is not a “piggy bank” for expensive vacations or luxury purchases.
Equity is also a buffer against foreclosure. About 10 percent of owners who lost their homes during the Great Recession had “negative equity” — the amount they owed on their homes was greater than the home’s worth. This combination of negative equity and weakened household budgets forced many homeowners to default when they could not pay their mortgages and could not sell their homes or refinance to pay off what they owed. Today, lenders restrict the amount of equity you can convert into cash to 90 percent of your total equity.
Here are some good reasons to cash out some equity:
- Make a down payment on a vacation home. You increase your equity sources by buying a second home or moving to a larger home.
- Pay a child’s down payment on a first home. You are passing along some of your equity to the next generation, where it will continue to grow.
- Pay college tuition or student loans. Contributing to a son or daughter’s education passes along some of your equity to your next generation and lessens the debt burden facing them when they graduate.
- Pay off consumer debt. High-interest consumer debt can eat you alive and cost more over a short period than the equity you cash in to pay it off. Please don’t wait too long to pay off delinquent consumer debt, or your credit score will suffer enough to make it challenging to refinance.
- Pay large medical bills. A severe accident or illness could cost much more than the cash most owners save for emergencies.
- Create an emergency fund. Put aside enough cash that you can access quickly for a medical or family crisis, unexpected travel, a weather-related disaster, and other emergencies.
2. Get a lower interest rate
Refinancing at a rate lower than the rate you received when you took out your current mortgage can save you tens of thousands over the life of your mortgage, but often rates change for reasons that most owners cannot anticipate.
Today’s rates may not be as favorable as a year ago, but from a historical perspective, they are still lower than they have been in many years. Even should the annual average interest rate on a 30-year fixed-rate loan stay below 5 percent in 2022, rates will still be the lowest in 30 years.
Time is only one factor that changes mortgage rates. Rates vary by lender, loan term, loan size, loan type, location, debt-to-income ratio, credit history, and credit score. Check out the weekly mortgage rates reported in Freddie Mac’s Primary Mortgage Market Survey to get the most current rate that all lenders use.
Reduce the loan term to increase monthly payments and pay off the mortgage faster or lengthen the period to lower monthly payments. You can shorten the term to a 20-year or a 15-year mortgage and pay off your mortgage faster by refinancing. But keep in mind, a briefer duration will increase your monthly payment.
Conversely, you can reduce your monthly payment considerably by refinancing into a 30-year mortgage from a 15-year mortgage. By doubling the term of your loan, you will significantly increase and reduce each monthly payment over the life of the loan.
3. Avoid higher interest rates by replacing an adjustable-rate mortgage with a fixed rate
Most adjustable loans begin with a low, fixed-rate over a predetermined period such as 3 or 5 years. Then the interest rate on the loan balance “floats” with the monthly movement of a financial index like the S&P 500 or the London Interbank Offered Rate (LIBOR).
As a loan’s introductory period nears, a borrower can avoid the risk of a floating rate by refinancing into either a fixed-rate loan or another adjustable-rate loan.
4. Lower monthly payments by lengthening the loan term or pay off the mortgage faster by shortening the term
If you want to lower your monthly mortgage payments, you can increase the loan term, which will spread the loan’s balance over a longer period. Conversely, you can pay off your mortgage faster by reducing the term. You will reduce the number of remaining mortgage payments, increase the size of each payment, and you will lower the balance remaining on your mortgage faster.
5. Get rid of private mortgage insurance (PMI)
Homeowners must pay for mortgage insurance when they put a down payment smaller than 20 percent of the home price. Owners with “conventional” loans (mortgages from a bank, mortgage company, credit union, or any private sector lender) must buy insurance from private mortgage insurance (PMI). Typically, monthly PMI premiums are about 1 to 2 percent of the loan amount. Borrowers can ask their lender to cancel their PMI when they have reached the date when their mortgage balance is scheduled to fall to 80 percent of the home’s original value. Your lender is required by law to terminate PMI when your principal balance reaches 78 percent of the initial value of your home.
Of the three government agencies with homeownership programs (USDA, VA, and FHA), only FHA requires mortgage insurance (called Mortgage Insurance Premium or MIP). It consists of an upfront premium equal to 1.75 percent of the loan amount paid at closing and an annual premium worth between 0.45 to 1.05 percent of the total loan paid in monthly installments. Unlike PMI (private mortgage insurance), FHA mortgage insurance (known as MIP) cannot be canceled and lasts for the life of the loan.
The only way to get rid of FHA mortgage insurance is to refinance into a conventional mortgage. Homeowners with a conventional mortgage do not need to wait until their balance falls by 20 percent. By refinancing into a new loan and putting down at least 20, homeowners can rid themselves of PMI.
When refinancing, FHA’s Streamline refinance is an excellent tool for self-employed workers who want to avoid the time and effort of documenting their income. Streamline refinancers require limited borrower documentation and underwriting. Borrowers can not take out more than $500 when using the FHA Streamline process.
6. Add a spouse or partner as a co-borrower
Having a co-borrower is generally a good thing when applying for a mortgage in these times of two-earner marriages and partnerships. By refinancing, an owner can add a co-borrower to increase annual income. A change in your marital status can change two crucial factors that determine the terms of your mortgage — income and debt.
7. Change the names on the mortgage after divorce or the death of a spouse or partner
If a divorced spouse remains on the mortgage, they may continue to be responsible for paying the mortgage and would have to agree to refinance a new mortgage. Start a new mortgage without the names of divorced or deceased partners.
8. Your credit score or financial outlook has greatly improved
The government-set interest rates isn’t the only issue affecting your credit score. Did you know that if your credit score has greatly improved, you may qualify for a better interest rate on your mortgage. Homebuyers in late 2020 had a median score of 786, according to the New York Federal Reserve Bank. If you’re score improved, do the following:
- Check your credit score
- Confirm that the score is much higher (20% or more) than when you first got your mortgage
- Speak with your mortgage broker or loan professional to see what your options are
Reasons to refinance your mortgage go beyond just interest rate
Now that you know all the various reasons to refinance, consider speaking to a professional to help you find what is the next best step. Feel free to also connect with me on social media if you have specific questions.