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Interest rates are low right now so you’ve probably heard a lot of people talking about refinancing their home mortgage. While refinancing can save you money, it’s not always a slam-dunk decision, especially when it comes to financial independence (FI).
When used correctly, refinancing a mortgage can be a great choice. When used incorrectly, it can lead you down a slippery slope of never paying off your debt. We’ll walk you through when and how to refinance your mortgage.
What is mortgage refinancing?
Mortgage refinancing works by taking out a new mortgage to replace your existing mortgage. Refinancing helps you change your loan terms by changing the length, the interest rate, or the amount of the mortgage.
Common types of mortgages
There are a number of different types of mortgages. Before jumping into refinancing, it’s important to be familiar with the different options so you know what’s available to you. Here’s a quick overview of the common mortgages you’ll see:
- Conventional mortgages (conforming): These are mortgages that aren’t backed by a government agency. Conventional mortgages can either be conforming or non-conforming. A conforming loan means that it meets the criteria set forth by Fannie Mae or Freddie Mac, two government-sponsored agencies.
- Conventional mortgages (non-conforming): Just like conforming conventional mortgages, these loans aren’t backed by a government agency. The difference is that they don’t meet all of the criteria required to be a conforming loan. A common type of non-conforming loan is a jumbo loan. Those loans have limits that are higher than what you’ll find with a conforming conventional loan.
- Government insured mortgages: The government isn’t in the business of making home loans, but they do insure mortgages under certain programs. The most common government-insured mortgages are FHA loans, USDA loans (for rural areas), and VA loans (for members of the U.S. military).
There are also two other loan types you’ll see: fixed rate and adjustable rate mortgages. A fixed interest rate means that the interest rate remains the same during the entire life of your loan. For example, a 30-year fixed mortgage means you’ll have the same fixed mortgage rate over the entire 30 year loan.
A variable interest rate (adjustable-rate mortgage, or ARM) means that your interest rate will adjust periodically. A common adjustable rate mortgage that you’ll see offered is a 5/1 ARM. With this type of mortgage, you’ll have a fixed rate for the first five years, followed by a mortgage rate that adjusts annually every year after that.
When should you refinance your mortgage?
There are a lot of reasons why people decide to refinance their mortgage, but not all of them make sense for someone on their path to FI.
Refinance to lower interest rate
When it comes to refinancing a mortgage, a primary driver for a lot of people is saving money. When you refinance to a lower interest rate, you not only lower your monthly payment but you also lower the total amount of interest you pay over the life of the loan.
For example, let’s say you have a $100,000 mortgage at 4%, with 30 years remaining. Your monthly payment (principal and interest only) is $477. If you stick with that loan for 30 years making the required monthly payments, you will pay $72,008 in interest!
Now, what if you can refinance that loan to a 3% interest rate, keeping all other factors the same. Your payment drops to $421 per month, freeing up an extra $56 of cash flow per month. Not only that but the total interest you pay drops to $51,912. You save over $20,000 in interest by refinancing it.
And because you’re on your path to FIRE, you’re not going to spend that extra $56 per month. You’ll probably invest it. Using an estimated annual return of 7% per year, that $56 per month will grow to $63,477 over 30 years.
While refinancing to lower your interest rate can be incredibly helpful on your path to FI, it’s important to also weigh the fees that lenders charge to refinance. You’ll probably be charged appraisal and origination fees, which can offset the savings that you’re getting from decreasing your interest rate. When shopping for a loan, crunch the numbers and weigh the cost of the fees against the savings.
Change to a Fixed or ARM
When you first signed your mortgage, you either received a fixed or variable interest rate. Refinancing can help someone switch from a variable-rate to a fixed-rate or from a fixed-rate to a variable rate. What are the benefits of switching?
- From ARM to fixed: When interest rates are low, someone who has a variable-rate loan may want to refinance to lock in a low fixed rate for the remainder of their loan. For example, if you’re four years into a 5/1 ARM, you might be worried about your interest rate going up in future years as you switch to the adjustable rate. Refinancing to a low-fixed rate now can lock in a low rate for the remainder of your mortgage.
- From fixed to ARM: ARM rates are often lower than fixed rates. For someone who doesn’t expect to own their home for more than five or 10 more years might consider refinancing to an ARM to take advantage of a lower rate for the initial fixed period of time.
Get a longer or shorter loan term
When you refinance your mortgage, your loan term essentially restarts. Your lender will usually offer you loan terms between 15, 20 and 30 years. Some people may use a refinance to pick a shorter loan term and pay off their loan faster. Others may default to getting another 30-year loan, which can decrease your monthly loan payments but stretch out the amount of time it takes you to pay off your loan.
For most people, their home is their largest asset. When facing financial challenges, some people naturally turn to their equity in their home. With cash-out refinancing, you can refinance your loan and pull out the equity you’ve built up in your home.
Cash-out refinancing is sometimes used by real estate investors who are using the equity in their investment homes to grow their real estate portfolio.
But it can be a slippery slope for people who are pulling cash out of their primary residence. We’ve probably all heard the stories of people who continue to pull the equity out of their home through cash-out refinancing to fund expenditures and stay chained to their mortgage for life.
If your goal is financial independence, cash-out refinancing probably isn’t the best option for you.
Is it better to refinance with your current mortgage company?
You can refinance with the same lender and there are some advantages to doing that. First, your relationship with them may make it easier to go through the process and finish refinancing quicker. They already know you and may not require quite as much documentation to complete the refinancing.
They may also offer lower fees than other lenders, especially if they are eager to keep you as a customer.
But refinancing with your current lender won’t always be the best choice. If your lender isn’t offering competitive interest rates and you’re not getting a break on fees, sticking with your current lender isn’t a good idea.
The goal here is to reach FI faster and if your current lender isn’t the best one to help you get there, it’s time to jump ship. Do your best to avoid personal relationships getting in the way of your financial future — a lender who doesn’t offer you the best rate isn’t worth your loyalty.
How to refinance your mortgage
Mortgage refinancing is a simple process, but it can be time-consuming to pick a lender and submit the final documentation they need. Here are the general steps you’ll walk through when you refinance your mortgage:
Set your goal for refinancing
What’s your goal for refinancing your mortgage? Are you hoping to take advantage of low-interest rates and save money on your mortgage? Or are you planning to change your ARM and lock in a fixed interest rate?
When you figure out your goals you’ll be able to better assess your lending options.
Check your credit history
Before starting the mortgage refinancing process, check your credit history. Lenders will check your credit before approving you for refinancing, so it’s important to know that what’s being reported on your credit history is accurate.
You can pull your credit history for free using AnnualCreditReport.com. Check it for errors and dispute anything that isn’t correct. Doing this before you apply will help you avoid surprises during the lending process.
There are a number of places you can look for a mortgage. Research your options and the types of lenders you might want to work with. Lending options include:
- Credit unions: Credit unions often have more flexible underwriting standards so they can offer mortgages to people who might have lower credit scores or smaller down payments. You might also find that they have lower fees and offer a more personalized service. But you usually have to qualify for membership before joining the credit union, so you’ll need to find a credit union you qualify for.
- Banks: Unlike credit unions, with a bank you don’t need to be a member to have a mortgage. You also will probably find more up to date technology than with a credit union and if you’re working with a large bank, you’ll have access to a network of branch locations.
- Mortgage companies: Also sometimes referred to as a direct lender, a mortgage lending company specializes in mortgages and doesn’t offer other services. They aren’t really that much different from a bank, but you might find slightly more relaxed qualifications with some of the lenders.
Another option is to work with a mortgage broker. These aren’t lenders — they are intermediaries that help borrowers find the right lender for a mortgage and may help facilitate the underwriting process.
Compare rates and fees
Lenders don’t all offer the same interest rates and fees. That’s why you should get quotes from multiple lenders — to make sure you’re getting the best deal. But it can get a little confusing keeping track of what each lender charges while trying to make the best decision about which loan will save you the most money.
That’s why our favorite tool for comparing lenders is Credible. Credible is an online mortgage broker, which means they help you find the right mortgage for you.
You don’t have to fill out multiple, time-consuming applications to get rates from different lenders. With Credible, you fill out just one application and you can compare rates from multiple lenders. Plus, the lenders Credible works with don’t charge prepayment penalties or origination fees, so you won’t be surprised by the end cost. And Credible is free to use and won’t affect your credit score.
Choose a lender
Once you’ve compared rates and you’ve found a lender that offers interest rates and fees that you like, it’s time to complete the application process with them. Your lender will ask for a lot of documents to verify your income, so be ready with your W-2, pay stubs, and tax returns.
Final approval can take time, so anticipate that your refinancing process will take at least 30 days to complete. Once it’s complete, your old loan will be paid off and you’ll begin making payments on your new loan.
Mortgage refinancing can be a great tool to help you lower your monthly mortgage payments and pay less in interest. But making sure you’re getting the best rate and not overpaying in fees does take due diligence and research. Take your time to crunch the numbers and make sure that the decision you make helps get you one step closer to FI.