One of the bright spots of 2020 has been lower mortgage interest rates. If you took out a mortgage over the past six months, you’ve likely taken advantage of record low rates, some even under 3%. If you aren’t looking for a new home, you may be wondering when to pull the trigger on refinancing your current mortgage. Here are some things to consider:
- Define your goal. If you want to reduce your monthly payment or pay less interest over the life of the loan, then refinancing may be a means to an end for you. However, if you simply want to take some of the equity in your home to buy other things, then that’s not usually a good reason to refinance.
- Avoid PMI. If you have less than 20% in equity in your home, you will most likely have to pay private mortgage insurance (PMI) as a requirement for the terms of the loan. But beware – if you decide to take equity out of your home to pay off other debts, you may reduce the equity of your home below the PMI threshold.
- Know your credit score. Rates also depend upon the borrower’s credit score. Typically, a credit score of 640 or better is required for a loan. You may qualify for a loan with a lower score, but understand that you may not get the best rates. The best rates are given for scores of 760 or higher.
- Do a ratio analysis. Lenders will crunch numbers to determine how you measure up to several benchmarks. Here are 3 common financial ratios they use:
- Consumer Debt Ratio: This is a ratio of monthly consumer debt payments (any debts other than your mortgage, like car payments & credit card debt) to monthly net (after tax) income. Generally speaking, your consumer debt ratio should not be higher than 20%.
- Housing Cost Ratio: This calculates monthly housing costs, including principal, interest, taxes, and insurance, as a percentage of your gross (before tax) monthly income. This ratio should not exceed 28%.
- Total Debt Ratio: This calculates monthly housing costs and consumer debt payments as a percentage of your gross monthly income. This ratio should not exceed 36%.
There are a few reasons to forego refinancing. Consider these points before committing to a new loan:
- You are planning to move within the next 2 years. If you don’t plan to stay in your current home, the savings you might see in a lower payment or reduced interest will be offset by the additional closing costs you will pay.
- Your credit score is too low. Work to improve your credit score by paying your bills timely and reducing your credit card debt.
- You can’t afford to pay the closing costs. If you have to include the closing costs in the loan, then you’ll be paying interest on those costs over the life of the loan. Remember, these costs are negotiable, so compare your options.
- You are greatly extending the length of your loan. A better rate is great, but if you only had 15 more years, and now are taking a new 30-year mortgage, extending the term for payments might not make sense, especially if that timeline is pushed into your retirement years. Remember, it’s not the interest rate that matters; it is the amount of interest you pay over the life of the loan.
If you are able to refinance your mortgage and lower your monthly payment, consider making the same monthly payment as you have now and using the savings to pay extra principal payments each month.
Do your homework to see if you are a good candidate for refinancing your home, and shop around to compare your options. It could result in a large cost savings if you can lock in a lower interest rate.