Unless you’ve been living under a rock, you’ve seen news reports touting record-breaking, rock-bottom mortgage interest rates. According to the Federal Reserve Bank of Saint Louis, the average 30-year mortgage interest rate plummeted by 33% from January 2018 to January 2021, from 3.95% to 2.65%.

While your book club pals have been swapping the names of mortgage brokers, you’re wondering whether you should jump on the refinancing bandwagon. After all, you wouldn’t want to miss out while everyone else is saving big bucks. So should you refinance?

With a refinance, you apply for a new home loan to pay off your existing mortgage. Most homeowners refinance to lower their interest rate, lower their monthly payment, or cash out on equity. The decision to refinance doesn’t boil down to simply lowering your interest rate, decreasing your monthly payment, or cashing out equity. For example, a homeowner with a goal to pay off their loan as quickly as possible could benefit by refinancing from a 30-year mortgage to a 15-year term, even if the monthly payment increases.

“There are many different ways a refi can be beneficial for someone. It’s all about what the borrower is trying to achieve,” comments Richie Helali, HomeLight’s Mortgage Sales Lead.

But refinance loans aren’t free. You’ll have to pay lender fees and third-party expenses to close your new loan. And there are some situations when, even with a lower interest rate or monthly payment, you may want to hold off on refinancing your home loan.

We asked Helali to weigh in on when a homeowner should step back before filling out that mortgage refinance application. Read on to discover why your overall financial picture plays a bigger role than a low-interest rate in determining whether or not you should refinance.

A woman researching on her phone to see if she should refinance her mortgage.
Source: (Chris Yang / Unsplash)

Think twice about refinancing if…

1. You’re planning to sell in the next few years

Between lender fees and third-party charges, refinancing can cost 1% to 1.5% of your loan amount, says Helali. For example, if your refinance loan saves you $150 per month and you’re planning to move in a year, you’d lose money if you spend $3,500 in closing costs.

One way to figure out whether it’s worthwhile to refinance is to calculate your break-even point, or the amount of time it will take to recoup the closing costs. To do that, Helali says to take the total closing cost and divide it by the amount you’ll save every month.

So, if refinancing costs you $15,000 and drops your monthly mortgage payment by $150, it will take 100 payments (or just over eight years) before you recoup the cost. If you’re planning to sell before the break-even point — eight years, in this example —  you end up losing money.

2. You haven’t built up substantial equity

Interest rates may be at historic lows, but if you don’t have at least 20% in equity it may be better to wait until either your home’s market value increases or you pay down your loan balance. If you refinance with less than 20% in equity, you’ll have to pay for private mortgage insurance (PMI) (or mortgage insurance for federally insured loans) or accept a higher interest rate. In some cases, lenders could also charge you more in closing fees.

If you plan to refinance with a cash-out loan (known as a cash-out refinance), the amount of equity you have is even more crucial. That’s because the equity in your home determines how much a lender is willing to loan — and how much equity you can cash out. “The more equity you have, the more cash would be potentially available to you,” says Helali.

To figure out how much equity you have, calculate your loan-to-value (LTV). First, divide your current loan balance by your home’s estimated value which will give you the LTV percentage. Then subtract the LTV from 100% and you get your equity percentage.

Not sure what your home is worth? Plug your address into HomeLight’s value estimator for a free automated valuation.

For example, a home with a $300,000 loan balance and a valuation of $400,000 has an LTV of 75%. Subtracting this figure from 100%, you have 25% equity.

3. You plan on applying for an adjustable-rate mortgage (ARM)

While fixed-rate mortgages maintain the same rate throughout the life of the loan, ARM loans only have a fixed rate for the set introductory period, usually 5, 7, or 10 years. After the introductory period, the rate adjusts at fixed time intervals. The interest rate changes based on the market index listed on your loan note, along with your lender’s margin.

For example, a 5/1 ARM has a set interest rate for the first five years of the loan. After the initial term, the rate fluctuates based on the market conditions of each year thereafter. To determine the adjusted rate, add the current index rate and margin as detailed in your mortgage note.

If your loan note lists the 6-month London Interbank Offer Rate (LIBOR) as the index and 2.5% as the margin, your fully indexed rate at the time of your rate adjustment would be the sum total of the two. So if your interest rate had reset in January 2021 when the LIBOR rate was 0.25%, your adjusted rate would have been 2.75% (2.5% margin plus 0.25% LIBOR) until the next adjustment period.

While it can be tempting to refinance into an ARM loan, which often has a lower introductory rate than a fixed-rate loan, it isn’t the right choice for everyone. After the introductory period, there’s a chance that the interest rate (and your monthly payment) could increase when the rate adjusts.

If you refinance to an ARM loan, the adjustable rate could make budgeting difficult, particularly if you’re on a fixed income or if your income fluctuates (if much of your income is commission-based, for example).

4. You recently refinanced your home loan

You refinanced a few months back, but interest rates have continued to drop. Should you refinance again? There are two factors you should consider: how much you paid in closing costs for your recent refinance and the cost to close on another loan.

If you haven’t hit your break-even point on your last refinance, you may want to reconsider — you’ll end up paying closing costs all over again with another refinance.

5. You have a low loan balance

Chances are, if you’re well into paying down your loan, most of your monthly loan payments are paying down your loan balance. The further along you are in your loan payment schedule, the smaller the percentage of your payment goes toward interest fees.

The bottom line: A lower interest rate probably won’t save you much. When considering the closing costs, refinancing a small loan balance may not have much financial benefit (that is, unless you’re planning to tap into your equity).

Also, it may be tough to find a lender that will accept a loan application for less than $100,000. Some lenders shy away from small-dollar refinance loans because they aren’t as profitable as larger loan amounts.

6. You recently turned your side hustle into a full-time gig

Did you ditch your day job less than two years ago? If you had a salaried position when you applied for your current loan and have since transitioned to running your own business, it could be tougher to get your refinance loan approved.

That’s because loan underwriters scrutinize self-employed borrowers differently than W-2 employees. Freddie Mac and Fannie Mae, the federally backed mortgage companies that buy and guarantee loans issued by lenders, require at least two years of self-employment to prove stable income.

Less than two years of self-employed income could be acceptable in certain situations, but you’ll have to document:

  • Sustained or increasing income
  • Your experience in the business, and
  • Demonstrate that the marketplace accepts the service or products of your business

7. You’re happy with the loan program and terms you already have

You shouldn’t feel pressured to refinance just because mortgage interest rates are low. If you don’t want to go through the time, effort, and paperwork of refinancing your loan, don’t feel bad about opting out.

“Refinancing is not required,” says Helali. “If you don’t feel comfortable refinancing, that’s OK, especially if you’re comfortable paying what you’re paying right now.”

A person researching online as to whether or not they should refinance their mortgage.
Source: (Towfiqu barbhuiya / Unsplash)

Hold off on refinancing if a new loan doesn’t meet your financial goals

Consider refinancing your mortgage loan as a tool to benefit your financial situation, not as bragging rights for scoring the lowest interest rate. Even if you’re quoted an ultra-low interest rate, it may not be the right time for you to refinance. Consider the big picture first, including:

  • Your current interest rate versus a new interest rate: Your new interest rate will not only impact your monthly payments but also how much interest you’ll pay over the life of the loan;
  • Your loan amount: A higher loan amount could mean a higher monthly payment unless it’s balanced out with a lower interest rate;
  • Your loan program: Moving from a fixed-rate loan to an adjustable loan could make it harder to budget for future mortgage payments;
  • Your break-even point: Ensure you’ll be in your home long enough to recoup your closing costs with monthly interest savings;
  • Your credit status: A change in your credit profile since your last loan application could make it more difficult to get a loan approval;
  • Your financial goals: Would you rather have a lower monthly payment, cash out equity, or pay down your balance quicker? Your financial profile and goals will help you decide which loan program suits you best; and
  • How the refinance will benefit you: A lower interest rate is just one potential benefit when refinancing. You can cash out equity or change your loan program to suit your personal goals.
A couple discussing refinancing their mortgage with their lender.
Source: (airfocus / Unsplash)

Still debating whether or not you should refinance?

You could test the waters by speaking with a few different lenders to learn more about their application and underwriting processes. If you’re still on the fence about refinancing, find out whether the lender charges an upfront fee before you get too far along in the process. Some lenders charge a non-refundable upfront fee to pull your credit report or order an appraisal, while others may require a fee to take your initial application.

Still having trouble deciding? Reach out to a financial advisor to explore whether it’s a good time for you to refinance your mortgage.

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