When interest rates dip low, refinancing your home or investment property becomes immensely attractive. But what exactly is refinancing, and what does it do for you? What steps are involved? How much does it cost? Should you even refinance your property in the first place? All these questions are very important.
While the concept of refinancing may not be too complicated—you’re simply changing the terms of your mortgage to more favorable conditions—there’s a lot more under the hood than you’d expect.
As a homeowner, you might have a different set of needs than an investor, and vice versa. Aligning your goals in both the long term and the short term is crucial when refinancing, which requires more in-depth knowledge of the various factors involved—discount points, amortization, private mortgage insurance, interest rates, how credit scores impact your terms, and more.
Regardless of your current position, refinancing can be a great way to reduce your monthly payments and create extra leverage in your life or business. But what is refinancing at its core?
What is refinancing?
Refinancing involves replacing your current mortgage with a new mortgage with better terms and rates. For instance, if you own a home backed by a 30-year loan with an adjustable, 4% interest rate, then your monthly payments are subject to change based on fluctuating interest rates. By refinancing, you can switch your mortgage loan to a fixed 3% rate, which lowers your monthly payments and locks that payment amount in place. That makes budgeting a whole lot easier.
There are many ways to refinance. A popular method for investors is a cash-out refinance, where you take out a mortgage worth more than you owe on the property. This gives you extra cash to use as a down payment on another investment or make improvements. We’ll talk more about refinancing methods later.
Why refinance your property?
Refinancing isn’t always the right thing to do. It isn’t free, and it requires a lot of paperwork and prepping. Frankly, refinancing can be a headache. Besides, it might not change your bottom line much anyway!
However, there are plenty of good reasons to refinance.
Lower your monthly payment
Perhaps the most obvious reason to refinance is to lower your monthly payments for the life of the loan.
Lower rates can make a big difference on your monthly payments. If your original mortgage interest rate is 5% and the market is currently offering 3%, refinancing offers two obvious benefits:
- Reducing your monthly payments
- Building more equity
If you’re an investor looking for more monthly cash flow, refinancing is just the way to do it.
Reduce the length of your mortgage
It’s possible to reduce the length of your home loan through refinancing. For instance, your original term may have been 30 years. With a refinance, you should be able to change that to a shorter term of 15, 20, or even five years.
Your payments might increase or decrease depending on the length of the loan’s amortization schedule, but the option is often available.
Take cash out
Cash-out refinancing is a popular way for a borrower to take out extra money for personal or business expenses. This can be used to perform home improvements, fund college, or pay off credit card debt or medical bills.
Another reason you might take cash out is to prevent balloon payments that you agreed to in the terms of your original loan. These payments can catch homeowners off guard and present a serious amount of risk to both the loan servicer and you. By refinancing just before your balloon payment(s), you can get extra cash by borrowing more than you owe—and reset the loan with more favorable terms.
A home equity line of credit (HELOC) does not involve refinancing, but it is another way to take cash out using your home equity.
Eliminate private mortgage insurance
Private mortgage insurance (PMI) is required on any home with less than 20% equity. Often, PMI removals are a product of appreciation during mortgage refinancing. If you bought your home five years ago on a full mortgage, then you’re probably not past the 20% threshold yet from payments alone. However, due to appreciation, there’s a chance your home’s value has created more equity, meaning you’ll qualify for PMI removal if you surpass 20% in total equity.
Refinancing isn’t the only way to remove PMI. Depending on your initial loan terms, you can request removal once your loan trickles down to 80%. You can also set up automatic termination at the 78% mark.
Regardless of how you eliminate PMI, it can potentially save hundreds of dollars from your mortgage bill every month.
Key refinancing terms
Refinancing can be complicated. Two key terms that you need to understand are discount points and amortization.
Discount points are fees you pay directly to the lender at closing to lower your interest rate. Another way of thinking about discount points is the phrase “buying down the rate.” One point costs 1% of your total mortgage and will generally reduce your interest rate by about 0.25%, although reductions vary.
For example, if you were purchasing a home with a $200,000 mortgage and 4.25% interest, you could buy a point for $2,000 and lower your interest to 4%, saving yourself extra with reduced interest payments over the course of your loan.
Discount points are not always cut-and-dry. Lenders don’t always offer reductions worth taking, so you need to evaluate whether it makes sense to buy points during a refinance. Questions you should answer include:
- How much of a financial impact will buying points make?
- Will you break even in saved interest costs?
- Will you keep the property long enough to make it worthwhile?
- When is the interest rate low enough for you?
The next key term to know is “amortization.” Amortization is essentially the long-term plan for how a loan will be paid off, accounting for interest and principal payments. Amortization loans—a category that includes mortgages—differ from other loan types, like revolving credit, because amortization involves “killing a loan” until it reaches zero.
Once the loan is at zero, you’ll have full equity in whatever asset you used the loan for.
Many homeowners and investors refinance to change the amortization schedule for their mortgages. This is typically done with a reduced interest rate, which alters the amount of money that goes towards interest each month and increases equity faster.
Alternatively, changing the length of the loan can affect the amortization schedule. This creates larger or lower monthly payments, altering the schedule of amortization.
Are you ready to invest?
One of the most frequently asked questions in the BiggerPockets forums is “How can I start investing in real estate with no money and bad credit?” The answer? You shouldn’t. You need to fix your situation and invest from a position of financial strength.
What you should know before you refinance
When considering a refinance, look beyond the current interest rates or the enticing idea of lower monthly payments.
There are plenty of reasons to refinance as a homeowner or an investor, but there are many factors to keep in mind before you do so.
The value of your property
Home values constantly fluctuate. Lately, home values have been skyrocketing, but that’s not always the case. Most of the time, homeowners with more than 20% equity in their homes will have an easier time qualifying for a conventional refinance loan than those who have less.
The reason? The more ownership you have in your home, the less risk for the lender. For one, having higher equity means you’ve been current on payments and have been for a while. Second, more equity means more collateral if you default. Finally, the lender won’t have to issue as much money, making the risk of loss lower.
Getting an estimate on your current equity can be achieved with an appraisal. Appraisers will determine what buyers would reasonably pay for your home, given the current market conditions. Whatever their evaluation amounts to, you subtract your current mortgage loan. This is now your equity in the eyes of the lender.
If you have less than 20% equity in a property, your options are limited. Your best options are to:
- Wait for appreciation to surpass the 20% threshold
- Make improvements to earn a higher appraisal
- Continue to make monthly mortgage payments on your existing mortgage
For investors, lenders might ask for even higher equity—likely around 25%. In an economic crisis, lenders assume that investors are more likely to default on rental property loans than their own homes.
Visit a mortgage lender and discuss your path towards refinancing. They’ll help you figure out what conventional loans you qualify for and whether government programs can help you refinance with low equity.
Your credit score
You might know that the higher your credit score, the lower interest rates you’ll pay. Lenders charge higher interest to those with lower credit scores to protect themselves from losing out if you default. In essence, they want to get whatever they can from you, just in case.
However, ever since the 2000 housing bubble catapulted into the Great Recession of 2008, mortgage lenders have tightened their lending requirements. Nowadays, you’ll ideally want a score above 750 to qualify for the best rates. Keep on top of those payments!
Mortgage lenders want to see that your housing debt-to-income ratio is below or at 28% before they qualify you for a new loan. Furthermore, they’re also checking to make sure your total debt is below or at 36% of your monthly income.
Consider paying off extra debt to lower those numbers before attempting to refinance. This will earn you the best rates possible and make refinancing worthwhile.
Simply put, it does not make a lot of sense to refinance your property just before selling. We’ll talk about closing costs later, but they can add up, making refinancing a break-even equation in many situations because there’s a stretch of time when you’re still in the red.
Furthermore, some loan contracts come with owner-occupancy clauses that require a homeowner to live in the home for a certain period. You need to read and discuss the terms found in your loan disclosure form with your lender to ensure your goals and intentions align with your mortgage.
Investors most likely won’t be living at their rental properties. Speak with your lender about different conditions for your loan. It might make sense to use a cash-out refinance to finance a new property or improvements and then sell the refinanced property.
Private mortgage insurance
You’re probably already paying for private mortgage insurance, so this shouldn’t make too much of a difference. But you should at least be aware that any homeowner refinancing a property with less than 20% equity will be required to pay PMI.
If you have more than 20% equity—and it will be hard to receive a new loan if you don’t—you don’t have to buy insurance coverage. Combined with lower interest rates, this could create serious reductions in your monthly payments.
However, let’s say you purchased your home with a large down payment surpassing 20%. But your home has depreciated, and you no longer have 20% equity (an unlikely but possible scenario). You would then be forced to pay the extra fee for PMI each month, making it important for you to keep tabs on your equity while considering a refinance.
Types of refinances
There are two primary types of refinances: rate-and-term and cash-out.
Rate-and-term refinancing is the standard process that most people understand. You swap out your current mortgage for a shiny new one with different terms and interest rates.
Generally, these types of refinances happen nationwide when Federal interest rates are slashed, such as when the COVID-19 pandemic broke out in early 2020. Of course, you can refinance at any time that makes sense for your situation.
Investors favor this type of refinancing due to the leverage it grants. Cash-out refinances allow you to borrow more than you need to pay off your original mortgage — meaning you can get extra cash at closing that you can use for other investments, debt consolidation, or other personal expenses.
There is a limit to how much you can take out, though. Generally, you can take out up to 80% or 90% of your home’s equity, depending on your lender. That allows for plenty of leverage.
The obvious drawback to these types of loans is that you have to pay back more than you would have with a traditional rate-and-term refinance because you borrowed more money. However, if the funds received are put to good use, then it’s well worth it. Just make sure you’re accounting for closing costs, which are usually 2-5% of your mortgage.
HELOCs and home equity loans
These two are not types of refinancing, but they’re often confused with them. HELOCs (home equity lines of credit) and home equity loans are based on the current equity in your property. While lenders differ on what they’ll offer, you can borrow a certain percentage of your equity based on your loan-to-value ratio (LTV). If you have a $400,000 mortgage and $200,000 in equity, then your LTV is 0.5. That means you can potentially get a loan on your equity of 30%, which would be $60,000.
HELOCs differ from home equity loans in that they’re essentially credit cards. Interest rates are variable, and you’re allowed to borrow whenever you need, up to a certain amount that your lender designates. Home equity loans are lump sums with a fixed rate.
Depending on your needs, the type of loan you should get varies. But they’re not to be confused with refinancing.
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The refinancing process
Refinancing can be summed up into five primary steps.
- Choosing a lender
- Locking your rate
Prepping for a refinance
When you’re getting ready to refinance, know that whatever lender you choose is going to want to learn about your overall financial health, including income, debts, assets, and credit scores. Documents you might need to present include:
- W2 forms
- Pay stubs
- Bank statements
This varies by lender. If you’re self-employed, a business owner, or an investor—or a mix—be ready to present additional documents.
You’ll also want to take this time to evaluate the current value of your property and see if there’s anything you can do to increase its value. To complete the refinancing process, you’ll have to get an appraisal. By making these changes now, you can create extra equity.
Choosing a lender
There are several different institutions you can approach. Whether you look at banks, financial institutions, consumer finance companies, credit unions, or savings and loan firms, you can find someone that will work with you—assuming that you’re qualified.
The real task when choosing a lender is comparing the offered terms and rates. Interest rates are often similar, but a slight reduction at one bank can save you a lot in the long run. Be sure to diligently sift through potential lenders to ensure you’re getting the best loan.
Locking your rate
Once you’ve selected a lender and they approve you for a new loan, you may be able to lock your rate. This means that you can keep your interest rate at a set percentage for the time it takes the refinance to close. This typically takes about 15 to 60 days, although the set time varies by lender, location, and the type of loan. If the loan does not close by the conclusion of the lock period, then you might be forced to extend it by paying a fee.
Sometimes, you can “float” your rate. This means you forego locking the rate in hopes that market rates decrease. However, you also run the risk of the interest rate increasing.
After you’ve submitted documents, been approved, and locked or floated your rate, you’ll go through the underwriting process. During this time, an underwriter conducts a deep dive into your finances and verifies all of your financial information.
This is also when a home appraisal will be ordered. Underwriters request an appraisal to help them determine whether the loan amount they’re giving you is suitable, but also to help you weigh your options. For example, if you’re an investor seeking a cash-out refinance, the appraisal lets you and the underwriter know how much extra cash you can take out. If the appraisal comes back lower than the prescribed loan amount, you can lower the mortgage amount.
You don’t always need an appraisal. For instance, if your conventional loan meets the Federal Housing Finance Agency (FHFA) standards for terms and underwriting, then you could get a waiver. The lender can simply use past appraisals and market estimates to come up with a value. Still, it might be in your best interest to request an appraisal if you think your home’s value has appreciated since you purchased it.
The lender’s final decision is made during the underwriting process. You’ll either be approved, denied, or suspended by the underwriter. If you’re suspended, they’re most likely missing information that you’ll need to provide. If denied, then you’ll be given the reasons for your denial.
If approved, awesome! You’re all set to close.
This is the final part of the process. Closing on a refinance is faster than closing on a home purchase since you’re avoiding the transfer of deeds, inspections, and other steps involved in a standard purchase. Before closing, you’ll receive your loan estimate and closing disclosure forms. These documents provide you with all the necessary information about your loan and its terms.
At closing, you’ll sign any necessary documents to finalize your loan and pay any closing costs that you owe (usually 2% to 5% of the mortgage). The lender will pay you any funds they owe you, such as in a cash-out refinance. After that, your property is refinanced.
Advantages of refinancing
Refinancing has several advantages. Here are some of the most obvious ones.
Lower monthly payments
The most obvious positive of refinancing is the opportunity to lower your monthly payments. Whether you change your loan’s term length, lock in a lower interest rate, or switch from an adjustable-rate to a fixed rate, lowering your monthly payment is the single most popular reason to refinance.
Pay off your mortgage faster
If you have the financial means to shorten your mortgage length and achieve full equity quicker, refinancing is a one-stop solution. If you have 15 years left on your mortgage, but you can handle the increased monthly payments during a five-year loan, then by all means, go for it.
Refinancing offers robust financial flexibility. Whether you need extra leverage to purchase a new property and increase your monthly cash flow or to avoid a balloon payment that you can’t afford, refinances can help you navigate the rugged waters of finance.
Disadvantages of refinancing
Refinancing requires serious consideration, and there are some reasons a refinance should be avoided.
Refinancing isn’t free. You’ll have to pay a few thousand dollars in closing costs. There’s nothing cheap about that. Most are willing to do it because they’ll save more money in the long term.
Breaking even isn’t a given
A pressing question for investors, in particular, is how long it will take for the refinance to break even in total savings. With closing costs and discount points included, there’s a significant investment made upfront to shave money from your monthly payments. If you don’t play your cards right, you could wind up losing money at the end of the day.
The freedom that comes with refinancing can be dangerous. In a cash-out refinance, you might take out more than you should, leading to a defaulted loan and severe hits to your financial wellbeing. Or you opt for a shorter payment term that requires you to make higher monthly payments, but you simply cannot afford it after a few years.
You must remain vigilant when refinancing and take a real, long-term look at whether it makes sense for you.
Is refinancing right for you?
It depends on your market, economic environment, and financial position. Refinancing makes sense if:
- Interest rates are low
- You can benefit from reducing your rate
- You have an adjustable-rate mortgage giving you no protection against erratic payments
- Your current loan term doesn’t match your goals
But on the flip side, refinancing isn’t right for you if:
- You’re not sure if you’ll ever break even after buying down your rate and paying for closing costs
- You plan on selling your property very soon
- Your financial situation is insecure or unstable
It’s up to you to evaluate your situation, adjust your goals, and determine whether refinancing makes sense for you. Remember, you can always talk to experienced real estate agents, investors, mortgage brokers, and lenders to get a better sense of your current situation.