I have been asked the following question many times recently: “I have X, Y, and Z going on. Should I refinance my house now?”
My answer is always, “It depends.”
Interest rates are great right now, but that doesn’t necessarily mean you should refinance your property.
After being asked about refinancing for the third time this week (and it is only Tuesday), I decided to tell everyone my thoughts.
There are many variables that play into this decision, and it would be unwise for me to answer this question without knowing all of them.
How much will the refinancing process cost?
When I debate if I should refinance my house the first factor I consider is how much the process of refinancing will cost. It is not uncommon for this process to cost close to $2,000 dollars (if not more).
This can often be rolled into the new loan amount, but it is still a cost to consider. Keep reading, and I’ll tell you more about why this is important in a minute.
Just this morning, I sent my bank a check for $900 to pay for an appraisal.
That’s right. I haven’t even started the refinancing process, and I’m already $900 out of pocket. Granted, this appraisal is more expensive than most because it is for a 10-unit apartment building, but be prepared to spend some money.
As the adage goes, “It takes money to make money.”
The average cost for appraising a single-family house in the U.S. is around $300-$400 dollars. This will, however, fluctuate based on the size and location of the property.
Points are generally thought of as the “origination cost” of a loan. A “point” refers to a percentage of the total loan.
One point = 1%
Two points = 2%
Five points = 5%
A $100,000 loan with an origination fee of “two points” means that you will pay $2,000 at the beginning of the loan. This does not come out of the principal of the mortgage, as it covers the cost(s) associated with their work to process the loan.
Not every lender or loan will charge points, but they are legally obligated through the Truth in Lending Act to outline all of the loan costs to you.
Mortgage application fee: tends to hover around $250-$500.
Flood certification: $50-$150 if in a location where this is required.
Title search and title insurance: These costs will vary, but your lender will want a new title search and most likely title insurance, even though it may seem silly to you. Expect to pay $200-$600 for the two of these.
As you can see, there are several different costs associated with refinancing a mortgage. Often, these costs add up to around 2-4% of the overall loan amount (after the refinance).
It is important that you cross-reference this with how much the loan payment will cost (after refinance) to see how long it will take to save the amount of money you spent on the refinance process.
How much will the new loan amount cost me?
People often refinance in order to save money on their monthly payment. For that reason, the next point I research when I'm debating if I should refinance my house is how much the loan will save me.
As I mentioned above, you need to cross-reference the additional savings with the refinance costs.
For example, if it costs you $4,000 to refinance a loan and your payment is now $100/month lower, it will take you 40 months to save the initial costs.
Over time, interest payments can definitely add up.
That being said, it doesn’t always affect your payment as much as you may think. Dropping from 4% interest to 3% interest would only save you $55/month on a $100,000 home.
While this savings is great, people often refinance for much less than a full 1% interest rate cut.
That is why there are so many variables to consider, rather than just the interest rate. You may find that refinancing is not worth your time, and that is okay.
The length of your loan can directly impact your current payments as well as total payments.
For example, let’s consider a $100k home purchased with a conventional loan. We will assume 20% down and 4% interest. I ran these calculations through this amortization calculator I found on Google.
Here is what this loan looks like amortized over 30 years.
The monthly payment is $477.42, and the total amount paid will be $171,870 over the duration of the loan. This translates to $71,870 in total interest paid.
Now, here is what this loan looks like amortized over 15 years.
The monthly payment is $739.69, and the total amount paid will be $133,144 over the duration of the loan. This translates to $33,144 in total interest paid.
By switching to a 15-year term, your home will be paid off twice as fast, AND you will save $38,726!
Of course, the downside is that your monthly payment is $262.27 more and will cut into your cash flow.
Loan duration is an awesome strategy to take into account when you’re refinancing. Instead of lowering your payment, you could decrease the loan term.
Your mortgage payment would remain about the same amount, but you could save tens of thousands of dollars in the long term!
Private mortgage insurance (PMI) is a requirement for loans when the down payment is less than 20% of the purchase price.
One of the few exceptions to this is the VA loan, another perk to this awesome benefit.
PMI costs 1.75% of the loan upfront and 0.55%-1.2% annually for at least the first five years.
This means that for a $100,000 home with 3.5% down (assuming FHA loan) your monthly PMI payment could be as low as $45/month and as much as $100/month.
PMI adds up quickly, and I definitely do not appreciate the $52/month I pay in PMI on my duplex!
For this reason, it may be worth refinancing with 20% equity so that you can eliminate PMI payments from your mortgage.
*Side note* Investment loans generally have higher interest rates than primary residences, so this may not always be worth doing. Painful as PMI is, it is better for me at this time than refinancing my duplex into an investment loan.
How long do you plan to own the property?
It is unlikely that refinancing is a good idea if you do not plan to own the property for much longer.
I always try to think about the long-term plan when deciding if I want to refinance my house.
As we discussed above, you need to ensure the money saved on the monthly payment justifies the cost(s) associated with the process of refinancing.
Sell After Duty Station
If you plan to sell your property when you PCS don’t waste your time with a refinance.
There is no way it is worth refinancing unless you have an exorbitantly expensive mortgage right now!
It is better to refinance while you live in the property if you plan on holding it long term as an investment property.
Investment properties usually have higher interest rates than primary residences do.
For this reason, it would be beneficial to refinance while you still live in the property, if possible.
If it is already an investment property, just ensure you plan to hold onto it long enough for the refinance to pay for itself!
In this situation, you can either lower the monthly payment (for increased cash flow) or lower the loan term (for increased principal pay down).
Refinancing your “forever home” is a great idea if you can save money on the payment and/or shorten the loan term to save money.
It is becoming less and less common for people to live in the same house until it is paid off. However, if you believe you have found the home you’ll live in forever, by all means, refinance to save money on the loan.
In this situation, I would absolutely lean toward shortening the loan term, as opposed to just lowering the payment.
You’ll save tens of thousands more this way!
Now that you understand the costs associated with refinancing, the loan costs, the consideration of property type, and the intended length of ownership, we are going to look at how these factors feed into various refinance strategies.
There are many different refinance strategies you can take. Here are the pros and cons of each!
The cash-out refinance is a favored strategy for real estate investors.
“Cashing out” is when you refinance, taking out a larger mortgage amount against the property. At closing, you receive a check for the difference between your new mortgage, and the amount you owed on the property before refinancing.
You can then reinvest (or spend) this money as you please.
For example, let’s assume that you owe $50,000 on a property worth $100,000.
When you refinance, the bank allows you to take out a new mortgage of up to 70% loan-to-value (LTV).
Once the refinance is concluded, you will have a new loan for $70,000 (70% of the $100,000 property value) and a check for $20,000 (the difference between the new/old loans) in your hands to “cash out.”
*Side note* The LTV varies from the lending institution to lending institution but is typically between 70%-80%.
- Money received through a cash-out refinance is not taxed.
- If your loan amount doesn’t change, this is essentially “free money.”
- You don’t have to pull the full amount out, so you could still maintain a low payment.
- Saying “I just completed a cash-out refinance” sounds cool!
- The more money you cash out, the higher your monthly payment.
- You are taking equity out of the property, which is not ideal.
- You pay interest on the money you cash out whether you use it or not.
Pay Off Debt
This is essentially a cash-out refinance, but you pay off high-interest debt with the money.
- You can pay off high-interest debt, such as credit card bills.
- This could be better than taking out a debt consolidation loan
- You are potentially extending the length of this debt to 30 years.
- This attaches the debt to your house, so if you can’t make the payments you could lose your home.
- You run the risk of utilizing your credit cards and getting into debt again, which puts you in a worse situation than you started. (Humans are fickle creatures and seem to do this strategy poorly).
How can you lower your mortgage payment?
You can lower your mortgage payment by refinancing to a lower interest rate and/or increasing the duration of the loan.
Lowering your monthly payment means you will receive increased cash flow.
*Side note* I don’t recommend extending the length of the loan. It may lower the monthly payment but will result in thousands of dollars more paid in interest over the length of the loan.
- It is easier to hold onto the property if the value decreases (the dreaded recession).
- More cash flow!
- If you increase the length of the loan to decrease the payment, you’re going to pay heavily for it long term.
- The lower monthly payments may take a long time to offset the cost of the refinance.
Shortening the Loan Duration
Instead of refinancing to pull cash out or lower your monthly payment, you could refinance to shorten the loan term.
As we saw above, lowering the loan term on a $100,000 property from 30 years to 15 years could save you almost $40,000 over the life of the loan.
You will have a higher payment in the meantime, but if your cash flow can sustain that, why not?
- The property will be paid off faster.
- You will pay much less interest over the course of the loan.
- You will build equity much faster by paying more of the principle down each month.
- Shortening the loan term will increase your monthly payment.
- Shortening the loan term will decrease your monthly cash flow.
Lock-In a Fixed Rate
Another reason for refinancing is to lock in a fixed rate.
This is especially effective if you have an adjustable-rate mortgage (ARM) and interest rates are low.
- Having a fixed-rate loan means that your payment can’t increase if interest rates rise.
- A fixed-rate loan is more predictable for budgeting purposes.
- Having a fixed-rate loan means that your payment can’t decrease if interest rates drop.
- If you lock in a bad interest rate, you could be stuck with it for a long time.
Should I refinance My House?
There are a lot of strategies you can use to refinance your mortgage, and some are better than others.
Ultimately, you need to weigh the cost of refinancing, the monthly payment of the mortgage after refinancing, your risk tolerance, and your long-term goals.
The decision to refinance (or not) and what strategy to use is yours to make.