Interest Rate
You have an option to refinance your home when the interest rates fall sharply. This will help you reduce your EMI and/ or pay off your loans faster. You may be eligible for a better interest rates if your credit score improves drastically.
Change in Income
If there is a significant change to your income/ earning, then you may want to switch to a more aggressive or conservative payment schedule i.e., switch from a 30-year fixed to a 15-year fixed or vice versa.
Move from Variable to Fixed
If you have a mortgage with guaranteed fixed rate for first 5 or 7 years. Then the loan turns variable. And your loan is about to become variable, and the variable interest rate is very high, they you may choose to switch to a fixed mortgage by refinancing.
Get cash in hand
This is an option during refinancing. Let us say that you had taken a $500,000 loan and have paid it for 15 years. The outstanding loan amount if $300,000 and you are planning to make a large purchase but do not have money. You can refinance your loan and increase your loan amount to (say) $400,000 and on closure the lender will give you a check of $100,000 minus the closing costs. Although this will increase your liability and loan tenure, it may give you money in your hand to make the large investment/ purchase that you wanted to make. This needs to be avoided until you are very sure of what you are getting into with a higher liability. Your decision should be based on all the factors that were described in the section on “key considerations for selecting the right mortgage”.
Key considerations to refinance
Closing Costs
You can technically refinance as many times as possible but each time you refinance, you will incur appraisal fees, attorney fees and several other such charges that will go out of your pocket to closet the new loan. In some cases, these charges would overwhelm you and not give you any benefits that you are seeking. As a thumb rule, if the interest rate drop is drastic (more than 0.75%) then it would make sense to refinance. Again, this will depend on a lot of factors like outstanding amount, tenure, age. You need to make the right determination of what’s right for you and get on a spreadsheet to see if it makes sense.
Clock Resets
If you are moving from a traditional mortgage to another traditional mortgage, then your clock resets and you fall back in the trap of lower principal payments and higher monies getting diverted to interest. This may prove to be a disadvantage and you would end up paying more interest overall compared to you sticking to the original mortgage.
Impact on Credit Score
Every time you refinance, the lender(s) will initiate a Hard Inquiry on your credit. This will impact your credit score as these inquiries usually stay on your score for a period of 2 years. Be cognizant of the impact before you refinance.
Buying Points to Reduce Interest Rate
There is another popular option provided by lenders when you are shopping for your mortgage. They provide you with an option to increase your closing costs and buy points to reduce your mortgage interest rate. For example, you can pay an additional $2,000 at closing and that would reduce your home mortgage rate from 3.25% to 3.125%. Whether this is going to be beneficial for you or not would need to be determined by running these numbers in an excel sheet to determine the overall Cost of the Loan (you will need to do an IRR comparison with your loan options).
As a thumb rule, it is usually not advisable to buy points to reduce your interest rates if (1) you are paying the money out of your pocket or (2) you have plans to pay off the loan sooner than the stated tenure or (3) you are opting for a 5- or 7-year variable rate.
In a few cases, the seller or broker agrees to contribute a certain amount towards the closing costs as part of the deal. If the amount being contributed by them is higher than your closing costs without buying any points, then you can use the balance to buy points as if you do not use that amount, you will lose it.
