Typically, mortgage in the United States are drafted for a 30-year term. While this might seem intimidating for a new homeowner or someone who has never had to manage a mortgage payment before, it's actually the standard and is designed with two things in mind:
- Most people purchase a home to live in for a long period of time, and you will always need some sort of roof over your head. With an average life-expectancy today in the mid-80s, most people will need to provide their own home for 40 – 60 years.
- Most people can comfortably afford to contribute 28 – 30% of their monthly income towards a mortgage, and therefore, the 30-year term is most likely to fit with the typical consumer and their available income.
But once you get into your mortgage, it doesn't mean that you are stuck with those terms forever. In fact, most homeowners will refinance their home at least once, if not more, during the time they own their home. Here are five key reasons to refinance your mortgage:
- Interest rates.
- Change the terms of the rate.
- Payments.
- Shortened term.
- Access your equity.
When deciding to refinance, the key reason is to introduce the interest rate, and this is often more popular than refinancing to reduce your payment, which we will share shortly. If you had poor credit or little credit when you first took out your mortgage, or you purchased a home during tough economic times, it is likely that you have a higher than necessary interest rate. So, be sure you are watching the market, or you stay connected to a reputable mortgage broker who will keep you updated. If more lucrative interest rates become available, strategize with your broker on options for refinancing to a lower rate.
A very popular reason for refinancing your mortgage is to shift from an adjustable-rate mortgage to one with a fixed rate. An adjustable-rate mortgage (ARM) is when you have an interest rate that can change up or down over time.
This means that the monthly payments can go up or down too. The initial interest rate is usually lower than that of a comparable fixed-rate mortgage, but after the that up-front period ends (usually after five or ten years depending on the mortgage), the interest rate, and payment, will increase or decrease. Most homeowners prefer a fixed rate mortgage over time as it makes it easier for monthly money management.
If you refinance to reduce your interest rate, your payment will inevitably drop too, even if you are refinancing and keeping the term expiration date the same. Sometimes, people also refinance because they need to or desire to lower their payment.
In these cases, homeowners are looking to refinance to an entirely new mortgage with a new term. For example, they have a 30-year term on their existing mortgage and have lived in their home for 10 years.
They then decide to refinance to a new 30-year loan, which then indirectly extends their mortgage to a 40-year term overall (the ten years they have already paid plus the new 30-year term).
On the flip side of extending a mortgage term to lower payments more than just dropped the interest rate, sometimes homeowners find themselves in a better position financially later in life than they did when they first took out their mortgage. In these instances, homeowners have two options.
1. Make extra payments to the mortgage on their own.
2. Refinance the mortgage to a shorter term
With either of the above options, the end goal is to make a higher principal payment each month to reduce the overall interest paid for the lifetime of the loan, and to get to the mortgage expiration date faster (paying off the home in full).
Home equity is the value of your home less what you owe. If your home is worth more than what you owe, and you have a need for some cash for home improvements, to pay for a child's college tuition, for out-of-pocket medical expenses, etc., then you may wish to refinance so that you can tap into that equity.
However, if you are using the equity for anything other than home improvement (which will add value to your home), it will take a lot longer to rebuild future equity, which might be important for you if you decide to sell your home and buy a new one (often times, homeowners use the equity from one home to pay for the down payment on a new home).
You will need to understand the requirements for refinance qualification.
In most cases, you will need a credit score of 620 – 680 in order to be approved for a refinanced mortgage. But, with a score lower than 740, you will likely not be eligible for the best interest rates, and this means that if you wanted to lower your interest rate and payment, this might not be the solution for you.
Keep in mind though that there are things you can do to increase your credit rating quickly. The best thing you can do is ensure you are paying your monthly expenses on time, and that you lower the utilization on any credit cards that you have. Your credit card utilization measures the amount of credit you're using divided by the amount of credit you have available.
A good rule of thumb is to keep your utilization below 30%, so if you are trying to improve your score quickly, get your utilization below 30%.
If you are looking to refinance your home, start by listing what it is you want to accomplish through the process.
If a refinancing will not help you reach those goals, then you will want to pursue other options, especially as refinancing can be time-consuming with home assessments (appraisals) and paperwork, and comes with fees tied to closing costs, which are either paid out-of-pocket at the time of closing or are built into your new mortgage.
