Refinancing a mortgage can be a smart financial move if you want to get a lower interest rate or monthly payment. However, such decisions may impact your credit score. This is why you should strategize about managing your debt by considering all the pros and cons as well as the relation between refinancing and your credit score.
Let’s dig in to understand all these seemingly complicated concepts and let’s make them easier for you.
What Is Refinancing?
Refinancing means you can apply for a new loan to pay off an existing debt. This loan generally has better or preferable terms than the original loan, such as lower interest rates, lower monthly payments, longer repayment periods, or multiple loan consolidations. Refinancing is often opted for when market conditions indicate a better interest rate scenario and financing situation. Or you have a better credit score!
How Does Refinancing Help?
Refinancing may prove to be a wise financial decision in several scenarios.
- Take Advantage of Lower Interest Rates
If the interest rates are falling, and you have a fixed-rate mortgage, refinancing to an adjustable-rate mortgage may benefit you with a significant amount of savings. On the other hand, if the market interest rate is rising, refinancing to a fixed-rate from an adjustable-rate mortgage might let you benefit from a lower interest rate.
Additionally, sometimes, irrespective of the loan type, if you want to avail a lower interest rate and want to give a small mortgage payment, and are ready to compromise on a long loan term and higher total interest on the new loan, other factors remaining constant, you are ready for the refinancing! You can certainly pay off your current loan soon as well. However, as a rule of thumb, you should be able to reduce your current interest rate by 1% or more, if you want to avail the benefits. - Consolidate your Loans
If your credit score has improved or you want to consolidate your loans, refinancing may be a good option. When you're struggling to make higher monthly payments, refinancing may help. Consolidation of debt would simplify the management of your finances. However, it would result in paying more interest over time. - Get Cash in Hand
A cash-out refinance can provide additional funds to pay off high-interest debt, make home improvements, or invest in other assets.
Yes! Refinancing can decrease your credit score. Here are the four ways how that can happen:
- Hard inquiries
When you apply for refinancing, the lender will likely perform a hard credit inquiry or a ‘hard pull’. This can lower your credit score by up to five points for almost two years. - Changes in Credit Utilization
Refinancing involves getting a new loan and paying off existing debts, which can impact the amount of credit you're using compared to your credit limit. If your credit utilization ratio increases after refinancing, it can lower your credit score. - Closing Credit Accounts
If you pay off a loan as part of your refinancing, the lender may close that account, which would be mentioned on your credit report as well. The extent to which your credit score would be impacted by the account closing depends on factors like account size and age. - Multiple Loan Applications
Whenever you apply for refinancing with different lenders, each application results in a showing up of hard credit inquiry on your credit report. This can potentially lower your score. However, to reduce the impact on your score, you can apply for refinancing to multiple lenders within a short period of time (between 14 to 45 days) depending on the credit scoring model.
How to Determine the Best Time to Refinance a Mortgage?
When contemplating whether to refinance a mortgage, various factors should be taken into account, including income, financial objectives, and the overall expenses linked with refinancing as well as your current debts. Additionally, favorable market conditions can make refinancing particularly advantageous. Sometimes, even a higher or improved credit score would let you think about refinancing. Just understand the process and your decision would prove to be fruitful in the long run.
Extending the payment period can result in lower monthly payments but also means that interest will accrue for a longer time. However, sometimes, your personal circumstances, such as the loss of a job, demand you to lower your monthly payments, and hence refinancing seems the best option. Also, if your income levels have become low, you may want to consolidate your debts. To determine if refinancing is the right choice for you, you can use a mortgage refinance calculator to calculate the break-even point. If refinancing can save you money, deem it as a perfect time to go ahead with your decision.
Another factor to consider is the interest rate. If interest rates are decreasing, switching from a fixed-rate mortgage to an adjustable-rate mortgage (ARM) may result in lower rates and smaller monthly payments due to the ARM's periodic adjustments. However, if interest rates are rising, converting to a fixed-rate loan may be the better financial decision, as periodic adjustments on an ARM could cause your mortgage's interest rate to increase.
If you are not a first-time buyer, and your house is in your possession for a long period of time, your house has built up equity. You can avail of this opportunity to make your refinancing easier. But, you shouldn’t forget that your refinancing would increase your debt years. So how can you choose whether to cash your equity? As a rule of thumb, if your home equity is less than 20%, you are obliged to pay PMI, which means that refinancing saving benefits would be lost to the PMI payments.
What are the Factors that you should Consider Before Refinancing?
It's essential to carefully consider various factors that can affect the outcome of the refinancing process:
- Closing Costs
When refinancing a mortgage, closing costs are a major expense that needs to be paid at the time of closing. This expense includes costs like origination, appraisal, title insurance, credit report, escrow, and recording fees. The total fee can range from 2% to 5% of the loan amount. This cost can take several years to recover.
If your goal is to decrease your monthly mortgage payments, lenders may tempt you with 'no-closing-cost' refinancing offers. However, this way the bank might offer a higher interest rate that negates any potential savings and defeat the original intent of refinancing. - Duration of your Stay
It's important to consider how long you intend to stay in your home when thinking about refinancing your mortgage. If you only plan on staying for a year or two, for instance, you might not have enough time to recuperate the upfront costs of refinancing.
On the other hand, refinancing might make financial sense if you intend to stay in your home for the next five to ten years. You might have enough time to save money in the long run and pay back the initial costs of refinancing. - Private Mortgage Insurance (PMI)
PMI is a type of insurance that protects the lender in case you default on your loan. You might have to pay PMI if you're refinancing a mortgage and your loan-to-value ratio is higher than 80%. Your monthly mortgage payment could increase by several hundred dollars as a result, and it could also lower your credit score.
After refinancing your loan, it's important to keep up with your payments and monitor your credit score. To safeguard your credit history, ensure there aren't excessive hard inquiries on your report and double-check that the new loan details reflect the correct refinancing terms. Consider using the money you save from refinancing to pay off other debts or invest for future benefits.
In conclusion, refinancing can be advantageous in many ways, including lower interest rates and monthly payments, modified loan conditions, and utilization of home equity. It's important to know that your credit score will likely drop initially. However, the credit inquiries associated with the refinancing will naturally disappear from your credit report within two years. You should speak with a financial advisor or a lender to know your options if you want to keep your good credit score and you're unsure whether refinancing is the best course of action for you.
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