A Guide To Mortgage RefinancingBy Mark Cussen | Published January 23rd, 2013
Home loans constitute one of the largest types of debt carried by consumers today. The ability to own a home free and clear without a mortgage is impossible for most people, so getting the lowest rate possible on a home loan is of vital importance to most homeowners. The continued volatility and uncertainty in the stock and bond markets has also made it harder than ever to get ahead, so when interest rates drop, many people have been able to improve both their cash flows and their balance sheets by refinancing.
Homeowners receive initial financing on their homes when they get approved for the loan that they use to purchase their homes. Refinancing is, conceptually speaking, simply acquiring a new loan to replace the old one. A homeowner can refinance by taking out a new loan that typically has better terms than the old one and use it to pay off the first loan. If you’re just buying your first house, check out Avoid These Common Mortgage Mistakes.
Refinancing can save homeowners thousands of dollars over the life of their loans. Homeowners who wish to reduce the terms of their loans, such as from 30 to 15 years, must also refinance.
Frank took out a $200,000 home loan at 4.5% for 30 years. His monthly payment is $1,013.37 and he will pay a total of $164,813.42 in interest over the life of the loan. After 5 years, he decides to refinance to a 15-year note. He has paid off about $18,000 of principal so far along with over $43,000 of interest and so he pays off an additional $2,000 up front to get a 15-year loan for $180,000 at 3%. The principal and interest on his new payment is $1,243.05, and he will only pay another $43,000 or so in interest over the entire life of the loan. Frank will therefore only pay about half as much interest after refinancing–even when including the interest he paid on the first loan–as he would have if he had stayed in the 30-year note. Find out everything that is involved with buying a home in Guide For First-Time Homebuyers.
Advantages of Refinancing
The example above clearly demonstrates how refinancing can make a real difference in the budget of the average homeowner. Although Frank’s monthly payment will be slightly higher than for the first loan, he will finish paying his loan off 10 years sooner than he would have otherwise. This has substantial financial ramifications for homeowners when it comes to planning for retirement or paying for kids’ college educations. Those who can pay off their home loans before these events occur will not need to save nearly as much money as those who cannot; a retiree with no mortgage payment can live on a much smaller amount of money per month with no investment risk of any kind. A retiree who has to make even the smaller payment from the first loan in the example above would need a portfolio of $200,000 generating about 7% to 8% per year (before taxes) in order to meet this monthly obligation without continuing to work. As well, if you are able to pay your mortgage off earlier, you can take the extra money and start adding even more to your dividend stock portfolio.
Disadvantages of Refinancing
Although refinancing is quite often well worth the cost and effort that is required, it is not always a wise course of action. It usually takes anywhere from 2-5 years to recoup the cost of refinancing; homeowners who refinance will have to get their homes appraised, which can cost up to $400 in some cases (and the fee is nonrefundable). If the home’s value is appraised at less than what is expected, then refinancing can become more difficult and expensive. There are also fees for recording, flood certification, title insurance, tax services and pulling a credit report. There may also be origination or discount points built into the loan that compensate the loan officer.
Homeowners need to run the numbers carefully in order to determine whether refinancing is a cost-effective move for them or not. It is also not wise in most cases to refinance to a mortgage with a longer term because of the enormous amount of additional interest that the homeowner will pay.
Another common mistake is to refinance using an adjustable-rate mortgage (ARM), which charges a very low “teaser” rate at the beginning and then adjusts to a higher rate that matches a benchmark rate index such as the LIBOR. For example, an ARM might only charge 2% for the first couple of years and then adjust to a rate of at least twice that afterwards. ARMs can be a good idea when interest rates are high, because if rates drop, then so will the monthly payment. They can be a fatal mistake for borrowers when rates are at historic lows, because they can only go up from there.
Just as they did when they first bought their homes, homeowners must have good credit in order to qualify for a decent rate of interest when they refinance. They should take the time to address any blemishes they find on their credit report before they apply and should check their debt-to-income ratios to see how they will look to the lender. If they have no money saved up, then they might be wise to accumulate some savings first and perhaps pay off any small debts that they have, such as the remainder of a car loan or their credit cards.
Some newer types of home loans, such as negative amortization ARMs allow for an alternate process known as recasting. This is a much simpler and cheaper process than refinancing, but it also requires homeowners to apply a substantial sum of money to the principal balance of their loans up front. Homeowners who wish to reduce their monthly payments can make a large lump-sum payment on their loans, and the lender will then recalculate a new payment based upon the same interest rate and term as before-but using the new lower principal balance. Recasting is available for both fixed and variable rate loans, although this process is rather seldom used for the latter type of loan, and not all lenders or loan investors will allow it. Some lenders will instead offer a loan modification that recalculates a new amortization using the same term but a lower rate of interest.
The Bottom Line
Refinancing is often viewed as a guaranteed way of saving money in an unsure world, which is true for the most part. Homeowners who qualify for a good rate should make sure that they will stay in their home long enough to recoup their refinancing costs. For more information on refinancing, consult your bank, mortgage lender or financial advisor.