If you have owned your home for a while, you may think about refinancing. Whether interest rates decreased or you need to tap into the equity in your home, there are many options available. Before you jump into any loan your current bank offers you, it pays to know the best refinance loan type for you. Each program available has its own benefits and drawbacks depending on your exact situation.
Refinance Loan Type: 30-Year Rate/Term Refinance
The most common type of refinance is the 30-year rate/term refinance. This program appeals to borrowers who just want to lower their interest rate. Because it is a rate/term refinance, you cannot take cash out of the equity of your home. This loan is best for borrowers who have a higher interest rate and want to lower it. However, there is one drawback – if you already paid several years on a 30-year term, you are starting back at square one. You should consider this before choosing this loan type.
As a general rule, we recommend the 30-year rate/term refinance only to those borrowers who see this as their long-term residence. Borrowers who know they will stay in the home for at least 10 more years usually benefit from this loan type. However, if you already paid 10 years on a 30-year mortgage, it may not make sense to start all over again. 30-year loans often have higher interest rates than the 15 or 20-year loans because the bank’s money remains outstanding for a longer period. If your loan is rather new and you stand to save money on interest, though, this loan type can be the right choice for you.
Refinance Loan Type: 15-Year Rate/Term Refinance
The 15-year rate/term refinance is just like the 30-year, with the exception of the term. This loan is due back in 15 years rather than 30. Because the amortization period is shorter, your payments are higher. However, your interest rate will likely be lower. This may save you money in the long run. We recommend this loan program to borrowers who can afford the 15-year payment comfortably. This enables you to either cut years off the original term of your loan if you had a 30-year term or to lower your interest rate without adding years onto your term if you already had a 20 or 15-year term.
Refinance Loan Type: Cash-Out Refinance – 15 or 30-year Term
If the reason you want to refinance is not to lower the rate or change the term, but to tap into the equity in the home, you need a cash-out refinance. These loans are riskier for banks, so they often carry higher interest rates. Before you can apply for a cash-out refinance, you need to know the value of your home. This helps you to understand how much equity you have in the home. For example, if you owe $200,000, but you find out your home is only worth $150,000, you are upside down on the home. Even if you owe $200,000 and the home is worth $205,000, you will not be able to find a cash-out refinance. Most lenders do not allow you to take out more than 85% of the value of the home in a cash-out refinance.
A few things to keep in mind with a cash-out refinance include:
- You will pay a higher interest rate to make up for the riskiness of the loan
- You need great credit in order for a lender to consider you for a cash-out refinance
- You need a low debt ratio to be able to include the higher mortgage payment in your monthly debts
Lenders usually offer both 15 and 30-year terms for cash-out refinances; however, the 30-year term is usually easier to qualify for because the payment is lower.
Streamline Refinance Programs
If you have a government-backed loan, such as an FHA or VA loan, you may qualify for a streamline refinance. This means you have to verify very little in order to refinance. Both the FHA and VA do not require:
- Income verification
- Asset verification
- Credit checks
All they require is that you make your housing payments on time. Neither the FHA or VA allows any late housing payments in the last year. They also do not like to see any late payments on any other type of debt in the last year. This is the only requirement they have to approve you for a streamline refinance outside of the fact that the loan must have a benefit. For example, if you can refinance from a 5% to a 3.5%, this is a benefit. You save money every month, which makes your loan less risky, so the lender can approve you for the streamline process. Under no circumstances can you take cash out of your home with a streamline refinance.
Finding the right refinance program for you depends on your long-term goals. For example, if you plan to move in the next 5 years, you may not want to refinance. The closing costs alone negate the benefits of refinancing. On the other hand, if you plan to stay in the home, refinancing to secure a lower interest rate or to take cash out of the property to fix it up may be beneficial.
In order to determine the right program for you, look at the big picture. Do not focus on the monthly savings alone. Instead, add up the closing costs and see how long it would take you to pay them off. For example, if you save $150 per month on your mortgage payment and closing costs equaled $5,000, it would take you 33 months to pay off the closing costs. This means you really are not saving $150 per month until almost 3 years later. If you move before then, you never saved any money. As long as you will stay in the home long enough to see the savings, it may be worth it for you.
Again, determining your long-term plans will also help you determine the right term. If you already paid 10 years on a loan, do you really want to start back at 30 years? What if instead, you refinanced into a 20-year program? This leaves you right where you left off, but hopefully with a lower interest rate or more cash in your hand if you took out a cash-out refinance.
Make the decision regarding the best refinance loan type for you carefully as it affects you for many years to come!