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When Should I Refinance My Mortgage Rule Of Thumb

When should i refinance my mortgage rule of thumb
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Refinancing, also known as “refi,” simply means you are reviewing the terms of an existing credit agreement. When you choose to refinance your credit commitment, you effectively seek to change your payment schedule, interest rates, length of the loan, and others. 

Consumer loans often considered for refinancing include mortgage loans, car loans, and student loans.

What is a Mortgage Refinance

A mortgage is a loan granted strictly for real estate. Refinancing your mortgage means as a homeowner, you want to get access to a new mortgage loan, which would replace the existing one. 

Mostly the terms reviewed in your mortgage credit agreement during refinancing are amounts borrowed, new mortgage rates, and length in years of payment.

When is the Best Time to Refinance Your Mortgage

When is the Best Time to Refinance Your Mortgage

Mortgage refinancing is common, whether rates are rising or falling, and it can save you money or cost you more. Understanding when to refinance your mortgage is incredibly essential. Let’s take a look at some of them.

Refinance to Reduce the Length of the Loan

As a homeowner, you sometimes could refinance your mortgage when interest rates fall. Without making many changes to your monthly payment, you could get a significantly shorter term.

For a 30 years fixed-rate mortgage on a $200,000 home, refinancing from 9% to 5.5%. You can cut the length of your mortgage by half with a slight change in your monthly payment from $1,609 to $1,634. 

On the other hand, if you are already on a 5.5% for 30 years, which comes to $1,135, refinancing to a lower rate of 3.5% will see your monthly rate rise to $1,430.

Live Scenario

“I don’t think I can refinance,” said Jamey K. of Sacramento, California. “I’m retired, and my income is much lower now — about half of what it used to be. I bought my house when I was working, and I barely qualified then.”

Let’s look at a scenario like that of Andy, who has 24 years left on his original 30 years mortgage but is planning to retire in 15 years. It would make sense for Andy to refinance this to be paid off when he retires because his income will be significantly affected, and unable to continue after retirement.

A 15-year mortgage will be just perfect for Andy. Check out the sample below for a better understanding.

Loan AmountInterest %15 – Year Monthly Payment30 – Year Monthly PaymentDifference
$160,0005.5$1,307$908$399
$200,0005.5$1,634$1,135$499
$250,0005.5$2,043$1,419$624
$300,0005.5$2,451$1,703$838
$350,0005.5$2,860$1,987$873

I used a constant rate of 5.5% but note that shorter-term mortgages usually attract lower rates.

Some points to take note of under this example…

  • If Andy is unable to make the higher payment, there’s a way out. He could get a 30-year mortgage with no prepayment penalty and pay a lot more cash than required. That way, he would have shaved off a lot of years and avoided interest payment.
  • Suppose he is getting preapproved for a mortgage or refinance. In that case, he only needs to ensure the new arrangement doesn’t include a prepayment penalty. 
  • With a 30-year mortgage with no prepayment penalty, Andy doesn’t need to refinance at all. He can shorten the life of his loan by just paying more money.

Refinance to Get a Lower Rate

The best and most common reason for refinancing is to get a lower interest rate on your existing mortgage. One rule of thumb is that refinancing can be worth it if there’s a difference of at least one percentage point between your current mortgage rate and the new rate you can get.

A lower interest rate helps you set aside cash. Also, it expands the rate at which you build equity in your home, and it can reduce the amount you pay monthly.

Using the previous example, a 30-year fixed-rate mortgage with an interest rate of 5.5% on a $200,000 home has a principal and interest payment of $1,136. That same loan at 4.1% reduces your payment to $966. That is a difference of $173. If you multiply this by what is left in the loan’s life, you would have saved a significant amount.

Prepare for Rate Drop

It is erroneous to wait until interest rates are in the news before you start the process of refinancing. That is because applications generally soar once it’s known that rates will fall.  

Banks have more business than they can deal with, which implies renegotiating a mortgage can take longer and cost more. Getting ready early with two smart moves prevents you from passing up a significant opportunity.

  1. Determine your target rate. Based on your incomes and other financial projections, at what interest rate will refinance make sense. Run your numbers repeatedly through a refinance calculator and see if the savings will surpass the loan’s cost over a reasonable time. If not, rerun the numbers with lower rates. Do this until it gives you the required desired saving. That is your “Target or “trigger rate.”
  1. Get Preapproved for your refinance. This will help you manage unforeseen challenges like errors in your credit reports – without being under pressure before a rate lock expires. When rates drop into your strike zone with a pre-approval, you can lock your credit and close your refinancing faster.

Refinancing to Merge Debts or Access Equity

If you have equity in your home, refinancing empowers you to cash out on that equity without applying for a new line of credit, for example, a home value advance.

Many individuals will use this money to pay for home repairs, college tuition, or make a big buy, for example, a vehicle. These kinds of refinancing are ordinarily simple to complete and may even be tax-deductible.

Refinance When Your Credit Score Improves

Low credit scores prevent you from being offered attractive interest rates. Assuming your score was down when you got your mortgage, but you have made significant improvements since then (by paying your bills on time, paying off credit card debts, and others).

Even in an environment where we see rising rates, you will be able to refinance and get a better rate. Using credit scores from FICO, you can see from the table below how your rates get better with improved credit scores;

FICO ScoreAPR %Monthly PaymentTotal Interest Paid
760 – 8503.879$941$138,735
700 – 7594.101$967$147,945
680 – 6994.278$987$155,378
660 – 6794.492$1,012$164,471
640 – 6594.922$1064$183,087
620 – 6395.468$1,132$207,364

Refinancing to Convert from ARM to Fix-Rate Mortgage

With adjustable-rate mortgages, your interest rate might be low at first and then increases over time. Refinancing to a fixed-rate mortgage would allow you to enjoy a lower rate.

Basic Requirements for Your Refinance Application

Basic Requirements for Your Refinance Application

Refinancing your mortgage goes beyond just trading one mortgage for another. There are basic requirements laid down by the lender and the loan program that you need to meet for your application to be considered. The process is similar to what you went through when you applied for the initial home loan.

Let’s look at some requirements you need to meet to qualify for a refinancing.

Credit Score

The Federal Housing Administration (FHA) or the Department of Veterans Affairs (VA) accept lower credit scores than other conventional loans not backed by the federal government. 

  • The FHA’s minimum credit score is 500 for a cash-out refinance and 580 for an FHA streamline refinance. 
  • The minimum credit score for a conventional mortgage refinancing is usually at least 620.
  • A minimum credit score for a VA mortgage refinancing is generally at least 620. Although, the VA doesn’t require a minimum credit score for VA Home Loans.

Debt-to-Income Ratio

Another primary consideration by refinancing lenders is to check if your income is sufficient to repay your mortgage. They additionally look at your debt load.

Your debt-to-income ratio (DTI) is the part of your income that goes into debt servicing or payment, including a mortgage. The lower the ratio, the better your chances of qualifying for refinancing at lower rates.

Home Equity to Refinance

Lenders usually require an appraisal or valuation to estimate the home value. Your home must be worth more than the amount you owe for refinance.

Home equity is the difference between the value of your home and your mortgage balance. If you are refinancing a conventional loan to get rid of PMI, your equity must be at least 20% of the home value.

A cash-out refinance replaces your current home loan with another more than you owe on your home. The difference goes to you in real money, and you can spend it on home upgrades, debt consolidation, or other needs. It would help if you had equity built up in your home to utilize a cash-out refinance.

FHA Home Loans

FHA will require at least 20% in equity to get qualified for cash-out. The FHA Streamline, on the other hand, does not require an appraisal, but the FHA Cash-Out does.

The maximum loan-to-value ratio after the transaction is usually 80%.

VA Home Loans

Home equity may not be required for a VA streamline refinance loan. 

Some lenders require an appraisal for a VA streamline refinancing, and they do have a cap for loan-to-value ratio, but VA doesn’t. 

A VA appraisal is required for a cash-out refinance. You might be able to get up to 100% of the appraised value of your home. This varies by lenders. 

Waiting Period for Refinancing

The rule varies based on the type of mortgage you took. There are waiting periods in some cases, while in others, you don’t need to wait.

You can generally refinance a conventional mortgage as often as you like if you don’t take out cash from the transaction.

To do a conventional cash-out refinancing, you will need to own the home for at least 6 months. The exception here is

  • Where you inherited the property
  • If it was awarded to you during a divorce, separation, or dissolution of a partnership

The required waiting period to refinance an FHA, VA, or USDA home loan varies from 6 to 12 months.

Taking it Home

Refinancing is a great idea, and you should take advantage of this opportunity when it opens up. Plan for it, listen, and watch the market for the best time you can refinance your mortgage. 

Knowing the rules of any game and playing according to that rule is what keeps you ahead of the competition. This applies to refinancing your mortgage too. Know the rule of thumb and use it accordingly. 

Refinancing becomes less complicated when you understand it and know when to do what. Homeowners like you are taking advantage of refinancing and enjoying lower rates, shorter terms, and other benefits.

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