By Emily Elmore | 20 April 2020
There’s a lot of chatter about how the Fed slashed rates, and how it could be the right time to refinance an existing loan, like a mortgage. While this is true, the trajectory of mortgage rates in March shocked forecasters when rates jumped nearly ¾ of a percent – which is a lot- instead of falling as predicted.
Mortgage rates fell in late February as the COVID-19 pandemic spread. Forecasters thought that mortgage rates would continue falling if the epidemic worsened, but mortgage rates went up instead. As the stock market started to plummet, bondholders sold their bonds to access cash, and these sales created instability in bond markets. Depressed bond prices, including prices for mortgage-backed securities, pushed mortgage rates higher instead of lower.
Not only that, because mortgage rates dropped so significantly in February, many lenders saw a surge in refinance applications. Operating at capacity, these lenders then raised rates in March to discourage their customers.
As of this week, however, the rates appear to have stabilized. And despite mortgage rates being higher than they were in February, they’re about one percentage point lower than a year ago. So we’re left with our original question: is now the right time to refinance?
The Refinancing Process
When you refinance, you replace an existing loan with a new loan that pays off the debt of the old loan. The new loan should have better terms that benefit your finances. With mortgages specifically, there are usually closing costs involved so it’s important to fully understand the terms and conditions -and costs- associated with refinancing. With any loan you’ll want to find out whether your lender charges a prepayment penalty if you pay off your old loan too early. If it does, you’ll also need to compare the costs of the penalty against the savings you will gain from the refinancing.
The process of refinancing is specific to loan type and lender, but typically involves the following:
- You have an existing loan that you would like to improve in some way.
- You shop around for lenders and find one that offers better loan terms than your old loan.
- You apply for the new loan.
- If your loan is approved, the new loan pays off the existing debt completely.
- You make payments on the new loan until you pay it off or refinance it.
What Refinancing Doesn’t Change
While you can adjust certain terms of a loan when you refinance, two aspects of loans do not change during a refinancing:
- Debt: When you refinance a loan, you will not reduce or eliminate your loan balance. In fact, you could take on more debt while refinancing. This might occur if you do a cash-out refinancing where you get cash for the difference between the refinanced loan and what you owe on the original loan or if you roll your closing costs into your loan.
- Collateral: If you used collateral for the loan, that collateral may still be required for the new loan. This means that you still can lose your home in foreclosure if you refinance a home loan but don’t make payments.
Advantages to Refinancing
- Lower your interest rates. A common reason for refinancing is to lower financing costs; to do so, you typically need to refinance into a loan with an interest rate that is lower than your existing rate by qualifying for a lower rate based on market conditions or an improved credit score. Lower interest rates typically result in lower interest costs and significant savings over the life of the loan, which is especially true of mortgages.
- Change the loan term. While you can extend repayment to increase the term of the loan (but potentially pay more in interest costs), you also can refinance into a shorter-term loan. For example, you might want to refinance a 30-year home loan into a 15-year home loan that comes with higher monthly payments but a lower interest rate.
- Change your loan type. If you have a variable-rate loan that causes your monthly payments to fluctuate as interest rates change, you might prefer to switch to a loan at a fixed rate. A fixed-rate loan offers protection if rates are currently low but are expected to rise and results in predictable monthly payments.
- Lower your monthly payments. If you lower the interest rate on your loan or extend the amount of time you’ll take to repay it, your new loan balance will most likely be smaller than your original loan balance because you will have lower interest costs or more time to repay.
Disadvantages of Refinancing
Refinancing is not always a smart money move; the drawbacks include:
- Transaction costs: Refinancing can be expensive. Although costs can vary by lender and state, be prepared to pay anywhere from 3%–6% of the outstanding principal in refinancing fees, which can include application, origination, appraisal, and inspection fees and closing costs. With large loans like home loans, closing costs can add up to thousands of dollars.
- Higher interest costs: Refinancing can backfire. When you stretch out loan payments over an extended period, you pay more interest on your debt. You might enjoy lower monthly payments, but that benefit may be offset by the higher lifetime cost of borrowing.
Upfront or closing costs might be too high to make refinancing worthwhile, and sometimes the benefits of a current loan will outweigh the savings associated with refinancing.
Instead of refinancing a loan, you can pay a little extra toward the principal each month to reduce the loan term and save a substantial amount in interest costs.
When You Should Refinance
The potential drawbacks aside, it can be worthwhile to refinance a loan.
Will you come out ahead financially? Do a break-even calculation to determine how long it will take for the savings from refinancing to exceed the associated costs. It could take a long time to recover those costs, and if you aren’t going to live in the property long enough to reap the savings, don’t refinance.
You’ve improved your credit score. If you damaged your credit score, you might have a loan or two with a high-interest rate. Maybe you lost your job, got divorced, had a medical emergency (‘rona, anyone?), or even filed for bankruptcy. Regardless of the reason, if you had to get a loan when your credit score was low your interest rate will reflect that. Refinancing when your credit score is still low won’t help your finances. But once you’ve improved your credit score, you likely can refinance those loans at a lower rate.
You want a home renovation/addition. If you have a lot of equity in your home, you can reinvest that equity to make some long-needed repairs or renovate the property. Assuming your credit is healthy, you can do a cash-out refinancing to trade the equity in your home for cash.
How to Refinance a Loan
Treat refinancing like you would any loan or mortgage. First, identify any credit issues that you might have and correct them. Check out current mortgage rates and determine which terms you desire in your new loan. Remember, these terms should represent an improvement on the terms of your existing loan.
Next, shop around to find a qualified lender with the best terms. Don’t just choose your current lender; get at least three or four quotes from competitors before inquiring with your current lender.
Don’t open any new credit during the refinancing process; it could hinder the deal. Before signing, carefully review the new loan terms and all associated fees so that you know what to expect financially when it’s time to make payments.
We’re changing the narrative around money but change can’t happen with a one-sided conversation. That’s why we’re excited to bring different voices and experts to share their wisdom. Send us an email and let us know what you think. And remember the nav.it money app offers you free tools like debt repayment calculators and checking in and managing your money moves.
You can download it at Google Play and the Apple Store.
Emily Elmore is a former Air Force pilot and combat veteran with an extensive background in technology and operations management. After being medically retired for losing functional use of her right arm, she became the Digital Director for Nav.it, a money management app that provides exceptional tools and community access to transform our money mindset and build financial wellness.