When you think about the word “refinance,” what immediately comes to mind? A lower monthly payment with a lower rate? Maybe getting your hands on cash?
In theory, a refi is something that always sounds beneficial to homeowners – but that’s not necessarily true. The reality is, a refinance is about striking at the right time, particularly when it comes to interest rates, home equity, and your financial and living situation. Refinancing without carefully considering these factors (and more) could end up not being in your best interest, so to speak.
Before you decide that a refi is the right move for you, ask yourself these 5 questions.
What is my financial goal?
Plain and simple: homeowners want to refinance to gain a financial benefit. It’s important to ask yourself this up front, because the reasons to refinance come in several forms.
With rates near historic lows, there’s a good chance the rate you got when you bought your home is higher than what lenders are currently offering now. Hence, the popularity of refinancing to a lower rate to reduce your monthly payment.
What about shortening your loan term? For example, you might be able to refinance from a 30 year fixed to a 20 or 15 year fixed. With this type of refi, you may save thousands on interest over the life of the loan and own your home outright faster. In some cases, you may be able to shorten your term without paying more each month.
Taking cash out of your home is another effective way to refinance. Are you in need of money to fund home improvements, pay for some college tuition, or consolidate high interest debt? A cash out refinance would allow you to access part of your home equity in the form of cash.
Do I have enough equity built up?
Home equity is fundamental to refinancing. So, if you’ve asked yourself “when can I refinance?”, it really depends on the loan you want to refi. First though, let’s make something clear. Equity isn’t just how much of your loan that you’ve paid down. It’s the difference between the property’s current value and the amount you still owe on the loan.
When it comes down to it, “enough equity” means a few different things. If you have a conventional loan, like a fixed or adjustable rate, you’ll need to have at least 20% equity built up to qualify, without having to pay private mortgage insurance. However, if you have an FHA loan, you can refi up to 97.75% of the home’s value, or have 2.25% equity.
Keep in mind: for some homeowners, adding PMI to their refinanced loan could nullify the benefits of a refi.
What’s my credit score?
Since you’re a homeowner, you know how important your credit score was in getting a home loan. Well, guess what? It’s just as instrumental to qualify for a refi AND get a good rate. But it all depends on the loan. Consider this breakdown:
- FHA loan: Typically, you’ll need a minimum score of a 580, with more favorable terms for those with a 600 or above. It’s also dependent on the type of FHA refinance.
- VA loan: The VA does not require a minimum credit score for a refi, though many, if not most VA lenders look for a score of 620 or greater.
- Conventional loan: Many lenders will accept a minimum score of 620 to 680. But that’s just to qualify. The best rates are usually given to scores of 740 and above.
Checking your credit score should be one of the first steps to take if you’re serious about applying for a refi.
When will I break even?
First off, yes, there is a cost of refinancing. Just like when you purchased your home, there are closing costs for refinancing, too. Therefore, it’s important to determine how many months or years it will take until the benefits of your refi outweigh the costs. To calculate the break-even point, divide the refinancing costs by the amount you’ve lowered your monthly payment.
For example: If the refinance will reduce your monthly payment by $175 but the closing costs end up being $3,500, it’ll take you 20 months to break even. So, if you’re thinking about moving in a couple years, it might not make financial sense for you to refi.
When calculating your break-even point, ask yourself how long you plan to stay in your home. Because as much as that number has to do with the associate costs, it has just as much to do with your future living situation.
How much will I spend in closing costs?
Your closing costs are dependent on several factors, including the purchase price of the home and the loan you’re refinancing. Generally, you can expect to pay between 2 to 5% of the loan amount. So, if your refinanced loan is $150,000, your closing costs would be between $3,000 and $7,500.
These questions and answers will be fundamental as you start making more decisions about your refinance. Ready to get a little more refi education? check out these common refinance misconceptions.
Ditech is not a financial advisor and the ideas outlined above are for informational purposes only. They are not intended as investment or financial advice and should not be construed as such. Consult a financial advisor before making decisions regarding important personal financial matters, and consult a tax advisor regarding the deductibility of interest and tax implications.