To refinance a mortgage means to pay off an existing loan by replacing it with another loan. Refinancing may be a wise financial move if it will reduce your mortgage payment, shorten the term of your loan or help you build equity more quickly. When used carefully, it can also be a valuable tool in getting your debt under control.
Refinancing mortgages is common for homeowners in the United States. People usually refinance for a number of reasons; to obtain a new loan with interest rates, to shorten mortgage term, to convert an adjustable rate mortgage (ARM) to a fixed rate one or to convert a fixed rate mortgage to an adjustable, to use a home’s equity to finance another purchase, or to consolidate a debt.
Two factors are involved in refinancing mortgages: money and time. Generally, the more money you can pay upfront, the lesser you need to pay in the long term. Similarly, the more money you need now or the lesser money you can pay upfront, the more you need to pay in the long run.
Learning the Vocabulary of Mortgage Refinancing
Refinancing lenders usually require a certain percentage of the total loan amount as an upfront payment for the processing of mortgage refinancing. This amount is usually expressed in “points” or “premiums.” Each “point” is equivalent to 1% of the total loan amount, so if you choose a plan that requires paying three points, then you will need to pay 3% of the total loan amount upfront. Refinancing lenders usually offer various combinations of points and interest rates that may suit a borrower’s needs. If you pay more “points” upfront, you would usually be allowed to acquire lower interest rates. “Negative points” (or discounts) means that the lender finances part of the loan.
After paying mortgage for a while and if your property appreciated in value, you should have built up some equity in your home. You can access this equity as money through a cash-out refinancing. Say for example your house is worth $200,000 and you still have an outstanding loan balance of $100,000 on your mortgage. You can refinance your mortgage for $150,000 and take the $50,000 as cash from the equity in your home.
A “no-cost” refinance is a loan in which you do not have to pay for the refinancing cost upfront and the cost of refinancing is recovered by your lender by adding to your interest rate. The cost of the refinancing transaction would just be built into the interest rate.
If you choose to refinance to a lower interest rate mortgage, you will end up saving money each month by lowering your monthly payment– that is if the other loan terms do not change. Since it also costs money to refinance, it is important to determine the break-even point by taking your total transaction costs and divide by your monthly savings. For example, if you save $100 a month by refinancing and the closing costs to refinance is $3,000, you divide the $3000 by 100 and your break-even would be 30 months or two and a half years from the time you refinance.
When and why do we need to refinance mortgages?
To secure lower interest rates on existing loans.
If you can reduce your interest rate by at least 2%, by rule of thumb, it is usually worth it to refinance. Some lenders even say that a 1% decrease is worth refinancing.
Reducing the interest rate will save you more money in the long run and will increase the rate at which you build equity and decrease the amount of your monthly payment. For example, a loan of $100,000 with an interest rate of 9% on a 30-year fixed-rate mortgage will cost you principal and interest payment of $804.62. The very same loan, if refinanced at a lower rate of 6% interest will decrease your payment to $599.55.
To shorten the Loan’s Term
Sometimes, it is also worth it to refinance even if the monthly payment barely changes as long as the term of payment shortens. For example the 30-year fixed-rate for the $100,000 loan on a 9% interest rate, if refinanced to a 5.5% interest will cut the term in half and only increase the monthly payment by a bit more that $10.
To convert from Adjustable-Rate to Fixed-Rate Mortgages or Vice Versa
Usually, adjustable rate mortgages offer lower rates than fixed rate mortgages although there are situations when the fixed-rate mortgage ends up being a better deal. In these cases it is better to refinance to a fixed-rate with a lower interest rate at the same time, securing yourself from any interest rate hikes in the future.
Sometimes, the better strategy is to convert from a fixed-rate interest loan to an adjustable rate mortgage especially if rates continue to fall. It is good to observe the trends and go for a conversion especially if you, as a home owner, do not plan to stay long in your home. This way, you would not have to always refinance each time there is a drop in the interest rates. Also, if you only stay in the home for a few years, it is less likely for you to suffer an interest rate hike. This will surely lessen the interest rates and the monthly payments.
To Tap Equity and to Consolidate Debt
To refinance for the purpose of tapping home equity and consolidating debt, it is important to really consider all the factors to avoid falling in the trap of never-ending debt.
Tapping Home equity for a “cash-out” refinancing is when you refinance for a particular amount higher than one’s current principal balance giving you extra cash for immediate needs. Usually home equity is accessed to cover huge expenses like paying children’s tuition fees or remodeling homes. Some say that home remodeling actually adds value to the home although the rates can still be tricky and the plan needs to be carefully reconsidered.
To consolidate a debt, especially by replacing a high-interest rate with one with a lower interest rate is pretty sound. However, this is ideal for those who can maintain financial prudence and avoid the temptation of maxing out on credit limits. Studies show that a rather large percentage of people who once generated high-interest debt on purchases and credit cards usually fall in the same cycle especially if mortgage refinancing gives them the available credit. If this happens, it is really more of a loss to keep on paying application fees to refinance, adding years to the term, or worse, losing equity in the house.
An added bonus for refinancing is to get rid of PMI. Usually homeowners who were unable to give a 20 percent down payment when they purchased their homes may have been required to purchase Private Mortgage Insurance (PMI). If the homes have appreciated since the time of purchase, as mortgage is paid consistently, the homeowners’ equity may actually be more than 20 percent by the time they refinance. For this reason, they wouldn’t need to purchase a PMI.
It is important to study closely the pros and cons of mortgage refinancing to make sure you get the best out of it.
Refinancing may cost 3% to 6% of your loan’s principal and it requires application fees, appraisal and such. Sometimes, the total of these fees outweigh the total savings generated through refinancing the loan.
Moreover, take note that many fixed-term rate debts have penalty clauses called “call provisions” which may be triggered by an early payment of the loan or at least a specified portion of it.
Also some mortgage refinancing loans may have lower initial payments but may actually result in larger total interest costs over the entire lifespan of the loan. Make sure to calculate the up-front, the ongoing, and even the potentially variable costs of mortgage refinancing to make sure you cover all risks.
Here are some valuable tips when considering mortgage refinancing:
- Ask yourself, “How much money will I actually save?” Make sure that the efforts and the application fees would be worth the extra money you will save. Again, refinancing will surely cost you three to six percent of your loan’s principal.
- Ask yourself this also: “How long do I plan to live in the house?” Remember, if you save up a few dollars on your monthly payment and yet, not stay in the house long enough, the cost of refinancing will actually work against your plan of saving in the long run.
- Think realistically and practically considering your finances closely. Look into what you can and can’t afford to make sure you are not just entangling yourself into more debt.
- Learn the law. There are federal protections instituted to avoid lenders from exploiting borrowers. To know what’s legal or not will help you sort through the unscrupulous lenders from the good ones.
- Don’t settle with a lender immediately. Look around and ask around. Make sure to ask knowledgeable people and if possible, ask for quotes from various lenders. By comparing the deals, you can decide on the best lender.
Compute. Some deals may sound and good at face value but actually may not be beneficial in the long run and conversely, some deals seem to offer trivial discounts but may actually give better results on a long term basis. Make sure to compute how much you will benefit in five, ten or even twenty years.