Should I refinance to pay for home renovations?

By Sabrina Karl

Refinancing a mortgage can be a powerful tool for homeowners. While it’s often done to snag a lower interest rate, another popular reason is turning your home’s equity into cash for home improvements.

Increasing your mortgage balance to renovate or repair your home may be reasonable, or even smart. But not always. You’ll want to consider the trade-offs carefully.

For instance, if refinancing will substantially raise your interest rate, it’s likely not a great move. Also, if you think you’ll sell your home within the next few years, opting for a home equity loan or line of credit will probably serve you better than opening a new mortgage.

You’ll also want to forego refinancing if you don’t have upwards of 20 percent equity in your home. That’s because dropping below this threshold will trigger private mortgage insurance, which is an expense you want to avoid.

Also keep in mind that refinancing isn’t free – you’ll incur some costs for the privilege – and it will involve running a credit check, so will impact your credit score.

But if you expect to keep your home five or more years, and can get a comparable or better APR on your new mortgage, refinancing can be a good source of funding for that home improvement project.

Renovations like major updates or adding to a home’s size are good candidates for tapping home equity since they’ll also increase the value of your home. But cashing in equity for a new roof can also make sense, especially if your only other option is accessing a credit card or other high-interest loan.

In any scenario, the smartest move is researching what the refinancing will cost, how your other funding options and costs compare, and how the new mortgage amount and rate will affect your monthly payments.

Can I prepay my mortgage?

By Sabrina Karl

With mortgages being the longest-lasting debt for most Americans, paying that obligation off early is tempting. And if you consistently have money left over after paying bills each month, investing some of that surplus in your mortgage can indeed be a smart move.

But whether it’s wise given your particular situation has to start with whether your mortgage allows it. Penalties for prepaying your mortgage were fairly common in the 1990s and early 2000s. They’ve since fallen mostly out of favor, but some lenders still impose them, especially for subprime mortgages.

So your first smart move before paying anything beyond your monthly obligation is to check your closing documentation or call your lender to find out if any type of prepayment penalty is stipulated. This is also a good question to ask if you’re currently considering a new mortgage.

Once you’ve held a mortgage five years, the chances are high that you’re safe from prepayment ramifications. That’s because the bulk of prepayment penalties target payoffs during the first two to five years of the loan. Paying off the debt in those early years by selling the home or refinancing can trigger the penalty.

But if you’re beyond the five-year marker, or are your using a lump-sum inheritance or other windfall to pay off some, but not all, of your mortgage, most lenders will take no issue with this prepayment. Similarly, adding a little extra to your payment every month or making 13 mortgage payments a year instead of 12 also typically doesn’t incur any penalties.

Whether mortgage prepayment makes sense for you depends on a variety of factors we’ll address in a future article. But no matter that conclusion, understanding the rules in place on your current mortgage – or a new one you’re considering – is a critical move.

Refinancing can be smart for mortgages above 5 percent

By Sabrina Karl

Although many homeowners have refinanced during the last five years of historically low mortgage rates, you’re not alone if you don’t have your own rock-bottom rate. Maybe your credit score prevented you from getting a top rate at the time, or perhaps you opted for an adjustable-rate mortgage that has since seen its rate rise. Or maybe refinancing seemed so daunting you just never got around to it.

Whatever the reason, if your APY is above 5 percent, you’re a good candidate to investigate refinancing. That threshold comes from two factors: a national average for 30-year fixed mortgages that’s currently hovering around 4 percent, and the rule of thumb that refinancing is often worth it when you can lower your rate by 1 percent or more.

Drop your rate from 5 percent to 4 percent on a $150,000 mortgage balance and you’ll save about $90 a month. But beyond the lower payment, you’ll also be putting more towards principal every month because you’ll be spending less on interest. That means you’ll build equity in your home more quickly.

Of course, some research and shopping around will be required. As the name implies, the national average is a middle number of all the mortgage rates currently on offer across the country. So while some lenders are charging more, you can find others charging less.

Obviously, the lower the rate you can lock in, the better, assuming the associated costs are reasonable. Fees vary widely, so shopping for your best option means comparing not just the rate for each mortgage, but also that lender’s estimated refinancing costs.

While some refinancing options carry a hefty expense that won’t make economic sense for you, others will be affordable enough that you can easily recoup the expense with savings from your new, lower interest rate.

What’s the difference between getting pre-qualified and pre-approved for a mortgage?

By Sabrina Karl

If you’re shopping for a new home, it’s smart to get a mortgage lender involved early. But does that mean getting pre-qualified or pre-approved? Knowing the difference can save you from a common homebuyer mistake and possible missed opportunities.

Pre-qualification is easier and comes first for most buyers. Based on debt, income and asset information you provide, the lender recommends the type and amount of mortgage they’ll likely approve for you. The process is quick and generally free, and involves no credit analysis

As a result, the pre-qualification amount is only an estimate of what you might be able to expect. If you’ve overlooked reporting any debts, have overstated income or assets, or have less than excellent credit, you may find out later your approved mortgage amount is less than your pre-qualification

Once you’ve gotten serious in your house hunting, it’s wise to apply for pre-approval and pay the fee it usually requires. Here, you provide information for the lender to confirm and analyze your debt, income and assets, as well as your credit score and report.

With this, the lender can commit on the type and amount of mortgage they’re willing to offer you, as well as the rate. This is conveyed in a conditional commitment letter, which confirms you have financing for homes at or below the approved amount.

If you’re sure you plan to buy, pre-approval offers advantages that are worth the application fee. Not only does it help you avoid wasting time on homes beyond your price range – it can also give you an edge with a seller, as it demonstrates you can move quickly without a contingency to secure financing.

Pre-qualification is a great first step for most home buyers, but as soon as the house hunt becomes serious, pre-approval becomes your next smart move.

What is the loan-to-value ratio?

By Sabrina Karl

For lenders, extending mortgages is a risk calculus. The riskier it seems that a homebuyer will repay their mortgage in a timely manner, the higher the rate the bank will offer. Meanwhile, for applicants appearing to be safer bets, banks extend more attractive terms.

One of the top-level measures lenders use to determine the risk factor of any applicant is the loan-to-value ratio. This calculation determines what share of the home’s value will be mortgaged, by dividing the requested loan amount by the home’s appraised value.

Take the example of a home appraised at $250,000. If you make a $25,000 down payment, the requested mortgage will be $225,000. Divide that by the $250,000 appraised value and you get a loan-to-value ratio, or LTV, of 90%. If instead you put down $50,000, the mortgage drops to $200,000 and with it, the LTV to 80%.

Lower LTV ratios will garner better rates, within certain tiers. For instance, 80% is the standard threshold at which almost all lenders will offer a lower APY. That’s not to say you can’t get a mortgage with a 90% or higher loan-to-value. FHA loans, for instance, are generally only provided for LTVs of at least 90%.

But while 80% is a worthy goal for any homebuyer aiming to get their best deal, dropping the ratio even lower can earn you still better rates. Most lenders will lower their rates at every 5% or 10% LTV mark, so putting enough money down to achieve a 75% or 70% loan-to-value ratio will reward you with a lower APY. There is a limit, though, with lenders typically stopping the rate drops after reaching a 60% LTV.

Once you know the home’s appraised value, understanding loan-to-value ratios enables you to target your down payment to secure the best mortgage rate available.

When it makes sense to refinance

By Sabrina Karl

When you took out a mortgage on your home, chances are you choose the best option for your needs at the time. But because personal and financial situations change, as do housing markets and interest rates, the best mortgage for you today is not always the same one you currently own. That’s when it may be time to refinance.

Even though refinancing isn’t cost-free, it can be a smart move for a wide range of reasons. Probably the most common motivator is to lower your mortgage interest rate. If currently available rates are 1 percent or more below your existing APY, refinancing may be worth the cost to lower the amount of interest you pay and therefore your monthly payments.

Others will refinance to change the length of their term, either shortening it, for example, to be debt-free by retirement, or lengthening it in tandem with lowering their rate because they want or need to minimize their payments.

Another attractive reason to refinance is if you hold an adjustable-rate mortgage (ARM) and either decide you’ll be in the house long enough to make a fixed-rate mortgage pay off, or see that your ARM is now charging more than currently available fixed-rate mortgages.

But there’s still another frequent reason for refinancing, and that’s to turn home equity into cash for other purposes. If you refinance to a loan amount that’s higher than your current mortgage balance, you’ll receive the difference in a payout. Many homeowners take advantage of this opportunity when they need to fund a large purchase or a home renovation project. Others will do a cash-out refinance to consolidate debt, such as paying off high-interest credit card balances.

In any case, refinancing involves costs and potential risks, so it’s important to weigh these carefully against your calculated benefits.

Why 15-year mortgages are worth a look

By Sabrina Karl

The 30-year fixed mortgage is the apple pie of home financing, with roughly 9 in 10 borrowers choosing the long-term option. But that doesn’t mean it’s your only or best choice. For many homeowners, a shorter 15-year loan offers considerable savings.

There are just two differences between 15- and 30-year mortgages: first, the length of the term, and second, because the lender’s risk with you lasts 15 years instead of 30, the interest rate. A rule of thumb is that 15-year rates run about 0.75 percent lower than their 30-year siblings.

For most borrowers, the choice comes down to affordability. A 30-year loan offers the lowest monthly payments, allowing the flexibility to buy a more expensive home than you could with a 15-year term, or leaving more money for competing priorities such as retirement or college.

But with a higher rate and a twice-as-long term, the 30-year mortgage will ultimately cost a great deal more than the 15-year option. Over 30 years, a $150,000 mortgage at 4 percent will cost about $258,000. Meanwhile, borrowing the same $150,000 for 15 years at 3.25 percent will cost just $190,000, saving you almost $70,000.

Of course, the benefit doesn’t come without its trade-off. The monthly payment for the 30-year loan will run about $716, while the 15-year mortgage will require committing to a $1,054 payment.

Still, if you can afford the higher payment and your income is reliable, the 15-year term will save a considerable sum, and get you debt-free sooner. Indeed, it’s a particularly great option for those approaching retirement.

Want the 15-year savings but leery of committing to higher payments? A hybrid is to take a 30-year loan but make payments at the 15-year level, still saving a substantial amount while retaining your option to make lower payments during lean times.

Home equity loan vs. HELOC

By Sabrina Karl

If your home’s value sits well above your mortgage balance, tapping into that equity for home improvements or consolidating debt can be a smart financial move. Both home equity loans and lines of credit allow you to do that, so which should you choose?

Both access the value in your home that belongs to you, but that you otherwise wouldn’t reap until selling the property. Both also offer lower interest rates than credit cards and personal loans since they’re backed by your home’s collateral, with the added bonus of the interest being tax-deductible.

The difference lies in how you’ll access the money. A home equity loan is like most other loans you’d request from a bank, where you apply for an amount and, if approved, the bank extends a lump sum at a fixed interest rate.

Home equity lines of credit, or HELOCs, work more like a credit card. The bank sets a limit based on your equity and lets you draw from the HELOC as needed, usually at an adjustable rate. Banks generally offer HELOC access via checks and bank transfers, with some also providing a debit card.

How you’ll use the funds will determine the better fit for you. Consolidating higher-interest debt? Then a home equity loan will work well, giving you a lump sum to pay off those balances and convert them to a single, more affordable payment going forward.

But if you’re tapping funds for home improvement, paying contractors throughout the project, a HELOC lets you borrow the money in flexible amounts at different times. A HELOC can also be useful as an emergency cushion, sitting untapped unless you need it.

With their low interest rates and tax advantages, home equity loans and HELOCs are among the most valuable financial tools available to homeowners with built-up equity.

How high a credit score do I need to get a good mortgage?

By Sabrina Karl

Whether you’re applying for a new mortgage or just refinancing, your three-digit credit score will factor heavily into how attractive a rate you can get, or if you’ll be approved at all. While those with the highest scores enjoy the lowest rates, mortgage lenders classify applicants into four tiers of scores to determine their offer.

The credit rating lenders rely on is your FICO score, which ranges from 300 to 850 based mostly on how often your payments have been on time, how much you owe, and how long your credit history is

Generally, the lowest score that can secure a mortgage is 620. One big exception is the government’s FHA program, which helps those with subprime credit. While an FHA loan can be secured with a score as low as 500, or 580 for the low-down-payment option, most applicants with scores this low are denied.

Once you surpass 620, you’ll have more options – and a chance at better rates – from conventional bank lenders. Boost your score higher to 660 and the number of lenders willing to take your application will increase again, with rates coming down further.

The next threshold is a score of 700 or better. Applicants with these “very good” scores have exceptional odds of approval, and the rates offered will be close to the best available.

So what then is the brass ring that earns the very best rates? That threshold generally sits around 750. Some lenders set the bar at 760, while others have published a 740 minimum, so it’s worth asking any lenders you approach what threshold they’ve set.

Knowing your score before applying for a mortgage can be a money saver if you find you’re close to the next tier. A few smart credit moves might be all it takes to earn yourself to a better rate.

What are mortgage points and should I pay them? →

By Sabrina Karl

One of the most confusing mortgage choices is whether to pay points. It doesn’t help that the term is used two different ways, or that the right answer varies by situation. But the good news is that you can boil your decision down with a simple math calculation. 

A “point” refers to one percent of your loan amount. So on a $200,000 mortgage, one point equals $2,000. You also need to be aware that lenders quote two kinds of points. Origination points are a fee you pay the lender for their services, and you may or may not be able to negotiate it.

But discount points are different, and are the ones borrowers find themselves dithering over. A discount point is a pre-payment of interest at the time of closing in exchange for a lower mortgage interest rate. It allows you to “buy down your rate”.

Lenders often let you pay one to three points, but we’ll use an easy one-point example. Opting to pay a point at closing typically lowers your mortgage APR by about a quarter percent (though lenders vary). So for a $200,000 mortgage with a 30-year fixed rate of 3.75 percent, paying one point, or $2,000, could lower your rate to 3.50 percent, which would drop your monthly payment from $926 to $898.

Now divide the cost of the point ($2,000) by the monthly savings ($28) to see how long it will take to break even. In our example, it would take 72 months, or six years, to earn back your $2,000 investment. Expect to stay in your home longer than that? Then buying points makes good sense.

Of course, if you can’t afford to bring more money to closing, or you have a higher-priority use for your funds, a no-point mortgage will be your own smart mortgage choice.