Updated 3.12.2018 to reflect changes enacted in the Tax Cuts and Jobs Act.
Neither a borrower nor a lender be, advised William Shakespeare — and in volatile times it’s tempting to follow his advice. But in an economy with low interest rates and rising home values, borrowing can be the right financial strategy.
To know if refinancing a mortgage makes financial sense for you, it’s important to base your decision on more than just a lower monthly payment.
Making the Decision to Refinance
You’ve probably heard it said that refinancing a mortgage doesn’t make financial sense unless the new interest rate is at least one percentage point lower than your current rate — and some say two percentage points.
The truth is, to know for sure you need to do the math, factoring in more than just the drop in interest rate. Additional factors to consider include the following:
The Amount You Intend to Borrow
The standard base limit for government-backed mortgages from FHA, Fannie Mae and Freddie Mac is $424,100 for 2017. Certain locations have higher conforming loan limits, up to $636,150 — including $592,250 for Seattle. If you intended to refinance a government-backed loan of more than this, you’ll need to find a private lender and likely pay a somewhat higher interest rate.
The alternative is a cash-in mortgage where you pay down the existing principal balance to reduce the amount you are refinancing.
Your Equity in the Home
Lenders prefer that you have at least 20 percent equity in your home, even in this period of rapidly rising home values. If you have less than 20 percent equity—in other words, your current mortgage represents more than 80 percent of the home’s value — you’ll generally be required to purchase private mortgage insurance (PMI). PMI protects the lender against default, but will add to the monthly cost of your new mortgage. You may also have to pay a slightly higher interest rate.
Traditional lenders won’t refinance your home if the amount you still owe on your existing mortgage exceeds your home’s market value. However, because millions of homeowners are currently under water on their mortgages, the federal government offers programs to assist qualified homeowners in this situation as part of its Making Home Affordable (MHA) program.
Your Credit Rating (FICO Score)
To get the best interest rate when refinancing a mortgage, you’ll need an excellent credit rating. Lenders use your FICO score, which ranges between 300 and 850, to determine your credit-worthiness. Generally, to qualify for the lowest interest rates, you’ll need a FICO score in the range of 740 – 750 or more.
If your FICO score is too low to qualify for the best rates, there are things you can do to increase it over time. They include checking your credit reports (Experian, TransUnion and Equifax) for inaccuracies and requesting corrections where appropriate; paying down or off your existing credit card and other debt; increasing available credit limits; and making sure that you pay all of your bills on time.
On the other hand, closing existing accounts can tend to decrease your FICO score, as can applying for new credit accounts.
The Length of Your Loan
The length of your loan has a major impact on its monthly and overall cost, and shorter loan terms generally offer the lowest interest costs in this economy.
Thirty-year fixed-rate mortgages, while among the most common, typically have the highest interest rates. They provide a lower monthly cost as they’re amortized over the longest period, but you’ll pay more in interest over the life of the loan since you’re carrying it for thirty years. Some also choose this longer term loan as they’d prefer to have less money invested in their homes and use the funds for investments that they believe will yield more in income or capital gains over the long term than the interest they’re charged on the mortgage.
Fifteen and twenty-year fixed-rate mortgages are increasingly popular for homeowners who can afford a somewhat higher monthly payment and want to pay off their mortgages faster — perhaps because of a planned retirement or other change in circumstances. These mortgages generally offer a somewhat lower interest rate and a smaller total interest cost.
Adjustable-rate mortgages, or ARMs, typically provide the lowest interest rates but they also generate the most risk as the amount you’ll be required to pay after the initial term is uncertain. They’re useful in situations where you know without a doubt that you’ll be moving out of your home before the initial term expires.
Some loans offer a bi-weekly or other unconventional payment schedules, which is generally the equivalent of making 13 monthly loan payments each year. This approach pays the mortgage off faster, but you should examine the terms carefully. Often you’ll find that your loan is actually being amortized on a monthly basis. A number of the payments you make are simply held as an administrative convenience to ensure you make the extra payment(s) each year — they’re not immediately applied against your mortgage. In other words, you lose access to your money without receiving an immediate reduction in the loan balance and related interest charges.
A better alternative may be to simply make higher-than-required payments at your option during the year, with the additional amount applied against principal.
Closing Costs and Loan Origination Fees
When refinancing a mortgage, you’ll be charged many of the same closing costs that you paid to secure the original mortgage, generally including an appraisal, mortgage broker fees, underwriting, application and administrative fees, title fees, settlement fees and document fees. You may also pay loan origination fees, more commonly referred to as points. It’s important to realize that many of these closing costs are negotiable.
Because closing costs reduce the financial benefit of refinancing a mortgage, it’s important to know the breakeven point — the point at which your monthly cost savings exactly offsets the closing costs. For example, if refinancing saves you $300 each month and your closing costs are $12,000, it will be roughly 40 months before you recover your closing costs for the refinance. If you sell your home before that time, your refinance cost will exceed the benefit you receive.
Although some lenders offer no-cost refinance options, they may recoup those fees with slightly higher interest rates. Others offer to roll the closing costs into the mortgage, increasing the balance and thus the interest you’ll pay over the life of the mortgage.
Although not common, there are mortgages that still charge a penalty if you choose to prepay, or even pay off the entire balance of the mortgage. Such penalties can increase the cost of your refinance.
You can generally deduct the mortgage interest you pay for mortgages taken out on your primary residence and one other qualified residence. Points are generally deductible on the purchase of a home, however they must be amortized over the life of the loan on a refinance. Such tax deductions effectively reduce your borrowing costs for the mortgage.
The actual amount of mortgage interest you can deduct for a qualified home may be limited based on several factors: the amount of the mortgage and the date you acquired it, as well as your reason for taking it out.
In general, interest on mortgages taken out on or before October 13, 1987 is fully deductible.
If you took out a mortgage after that date (and before December 15, 2017) to buy, build or substantially improve a home, it’s considered home acquisition debt and the interest is deductible on the debt up to $1,000,000 ($500,000 if married and filing separately). If you took out the mortgage after December 15, 2017, the interest is only deductible on debt up to $750,000 ($375,000 if married and filing separately.)
When you refinance a mortgage you took out prior to December 15, 2017, the mortgage remains home acquisition debt and the old limitation of $1 million continues to apply — but only up to the amount of the mortgage immediately before it was refinanced.
If you took out a home equity loan or home equity line of credit after October 13, 1987 for any purpose other than buying, building or substantially improving the home, it’s considered home equity debt and the interest is deductible on the debt up to $100,000 ($50,000 if married and filing separately). This deduction expired in its original form after 2017. However, if the debt was acquired to buy, build or substantially improve the home, it may be deductible as home acquisition debt, subject to the overall $750,000 limit.
A mortgage is, above all else, a long-term loan, so the amount you could earn by investing the borrowed funds elsewhere can also impact your decision-making.
If you believe you can earn more over the long term by investing your money — for example, earning five percent on investments while paying four percent for the mortgage — you may prefer a longer-term mortgage. If you believe you will earn less, you may prefer a shorter term or even a cash-in refinance, where you reduce the mortgage balance as part of the refinance.
Determining the true after-tax cost of carrying a mortgage, including all of the considerations mentioned above, can be a complicated analysis. We can help you run the numbers to see if refinancing is really the best financial decision for you.
Tips for Selecting and Securing the Best Loan Product
As with any major financial transaction, begin with a goal or strategy in mind. Are you considering refinancing a mortgage to reduce your monthly payment? Perhaps you want a shorter term to be able to pay off the loan before you retire — or, alternatively, extend the term of the mortgage to provide a low-interest loan and free up funds for more lucrative investments. Or maybe you simply want to move from an adjustable-rate to a fixed-rate loan.
Prepare Your Supporting Documents
Mortgage rates fluctuate. You can ensure that you’re prepared to take advantage of what may be a very short-term opportunity by having the necessary financial records assembled for your lender or mortgage broker. In most cases, you lock in your rate for between 30 and 45 days. If it takes longer to provide requested documents, you may wind up paying a higher interest rate.
The document requirements vary from time to time and lender to lender. Generally, you’ll need to provide supporting documents in the following categories:
Income If you’re employed, you’ll need the name, period of employment, monthly income and contact information for your most recent employer(s). You’ll also need W-2s and two recent pay stubs, and tax returns for the past two years.
If you’re self-employed, you’ll need signed copies of your federal income tax returns for the last few years, as well as your business license and a year-to-date income statement.
Finally, if you’ve asked your lender to consider other income — overtime or bonus income, social security, investment or pension income, or child support, for example — you’ll need canceled checks, bank or brokerage statements, tax returns, or other similar documents as verification. You may also need court records to document the child support you’re entitled to receive.
Assets and Investments Assemble all supporting documents for major assets and investments, including two months of statements for mutual funds, brokerage accounts and bank accounts.
Creditors Prepare a list of all of the money you owe — including the balance and required minimum payments — for your credit cards and consumer debt, car loans, student loans and any other indebtedness. Also include any child support payments you’re required to make.
Compare Quotes from a Number of Lenders
To get the best interest rate and other terms for your refinance, it’s important to shop around.
Consider checking with trusted friends and colleagues for specific referral recommendations. You can also use a mortgage broker to find the best rate and terms, or you can use an online service such as LendingTree, Zillow, Rate Marketplace or NerdWallet.
Review Your Loan Documents in Advance
As many homeowners have found to their detriment in recent years, you shouldn’t agree to anything you don’t fully understand.
That means you should never sign any legal document, financial or otherwise, without reading it through yourself, thoroughly. If there are aspects that you find confusing, ask your loan officer for an explanation. If you’re still concerned, speak with us, your attorney and/or another knowledgeable person that you trust to act in your best interests.
It’s hard to gain a thorough understanding of a long legal document during the typical brief appointment to sign the final loan documents. Ask for copies of the documents in advance, so you can review them carefully at your home or office and then discuss them with your advisors.
If you have questions about the financial or tax implications of refinancing a mortgage — or would like to see and discuss comparative amortization schedules for different loan products — give us a call.
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