Mortgages are complicated. Looking to swap one mortgage for another by refinancing? They get even trickier. So it pays to understand how the mortgage refinance process works and when refinancing is a good idea (and when it’s not) early in life. That is, even before you buy your first home.
Refinancing is just a fancy word for trading an existing mortgage for a new one with different terms. There are a number of reasons somebody might want to refinance, including:
- To get a lower interest rate.
- To change the repayment term (either longer or shorter)
- To lower a monthly payment
- To change the type of mortgage (adjustable or fixed rate)
- To take cash out of home equity
- To eliminate private mortgage insurance (PMI)
Before you think about refinancing for any of the above reasons, however, there are several things you need to know.
1. It Costs Money to Refinance
Most people say, “If I interest rates have dropped since I got my mortgage, why wouldn’t I refinance?” The answer? If you’re not going to be in the house long enough to recoup the refinance closing costs. Answer? It costs money to refinance a mortgage. These “closing costs” come in a variety of fees and mortgage points and may be paid for either with cash or by being added to the principal of the new mortgage. Either way, you pay them. And either way, they subtract from the money you will be saving by getting a lower interest rate.
As an example, if you owe approximately $148,500 on a $150,000 mortgage at 8% interest and want to refinance at 7.5% but there are $2,500 in closing costs, it will take you 41 months to recoup those costs. Of course, even a 0.5% rate reduction will save you thousands over the course of the mortgage, but if you were to sell the house in less than three and a half years, you’d lose money by refinancing.
The lower the rate, the faster you can recoup your investment in the refinancing costs. For example, if you dropped your rate from 8% to 6%, it’d take just 12 months to recoup the closing costs.
2. Lower Monthly Payments May Equal Lots More Interest
Especially in these challenging economic times, refinancing is an attractive option for creditworthy homeowners who face reduced incomes and want to lower their mortgage payment. Although getting a lower interest rate will reduce your payment, extending the term of the mortgage also achieves this goal.
Most mortgage refinances are done at standard mortgage terms (15 and 30 years being the most common). That means if you’ve owned your home for three years and have a 30-year mortgage, when you refinance, you’ll have a new 30-year repayment schedule, not another 27-year loan.
For homeowners that have been in their homes even longer, refinancing to a new 30-year mortgage can substantially lower their monthly payment. The problem is they’ll end up paying tens of thousands more in interest because they’re extending the number of years they’re paying off the mortgage.
Obviously, refinancing with a longer term is a better option than foreclosure; but it should be seen as a short-term solution. Hopefully, you can increase your income and begin making larger mortgage payments or make a plan to sell the home and get into something more affordable.
3. “Cash-Outs” May Cost You
So-called “cash-out” refinances, when a borrower refinances a mortgage and takes a portion of the home equity out in cash were once an immensely popular way of funding everything to home improvements to kids’ educations. As the real estate and mortgage markets have stumbled, however, cash-out refinances are not only harder to do, they’re less and less attractive.
In order to even consider a cash-out refinance, you need to have significant equity in your home. Generally, you can cash out your equity minus twenty percent. Take any more than that, and you’ll be back to paying private mortgage insurance (PMI), which banks require when you have less than twenty percent equity in the home. Go back to PMI, and that refinance is one expensive loan.
Cash outs are risky for a number of reasons. For one, you’re essentially just piling on “bad” debt and hiding it in your mortgage. Second, if you’re cashing out for home improvements that you expect to recoup in the sale of your home, you’re gambling that the market will go up and your improvements will work to increase the home’s resale value. Treat your house as your home, not an investment.
The one good use for a cash out refinance I might believe in is to use the equity to purchase (hopefully outright) a rental property that will generate income that will help pay the mortgage. A rental property that generates income is an investment. Still risky? You bet. But it’s a risk with an appropriate potential reward.
4. Shop for a Refi Until You Drop
The last big thing to know about refinancing is that every bank is going to price and structure refinance offers differently. These days, you’re going to need spectacular credit to even be considered for a refinancing offer. And even if you’ve got it, banks may play hardball.
Before you look into refinancing, know what you want to get out of it, and know where your break even point is. It doesn’t make sense to refinance if it’s not going to either save you money or save your house!
If you think you can get a lower rate and stay in the home to realize the savings, then go for it. If you want to lower your payment by changing your mortgage term, proceed carefully. If you’re trying to get cash out of your home, definitely stop and think. Still thinking about it? Shopping for refinancing doesn’t have to be difficult, and you can even get mortgage refinance quotes online from loan aggregation sites that will help you compare and choose banks to deal with.
What About You? Have you refinanced a mortgage? Why’d you do it? Did it work like you wanted it to? What did you learn? Please share your story in a comment.