When does it make sense to refinance a mortgage loan?
When you refinance, you pay off your existing mortgage and create a new one. You may decide to combine a first mortgage and a second mortgage into a new loan, or convert some of the equity in your home into cash to retire other debt, remodel, or pay for college. Refinancing may remind you of what you went through in obtaining your original mortgage, since you encounter many of the same procedures — and the same types of costs — the second time around.
The best reason to refinance is to lower your interest rate. The interest rate on a mortgage corresponds to your monthly payments. All other things being equal, lower rates mean lower payments. You may find a lower rate because of market conditions or because your credit score has improved. A lower rate will allow you to build equity in your home more quickly.
Let us look at several examples (data generated by the the Bills.com mortgage calculator). Let us compare the monthly payments for two 30-year, fixed-rate mortgage loans of $100,000 — one at 5.25% and the other at 6.25%.
|Total Interest at Year 30||$121,658.19||$98,793,33|
|30-year Interest Savings||$22,864.86|
A refinance may allow you to increase or decrease the term of your mortgage. You may want a longer term to cut the amount you pay each month. But, increasing the term will increase the total amount you pay toward interest. On the other hand, shorter-term mortgages almost always have lower interest rates, and because you pay off your loan sooner, this reduces your total interest cost.
Now let us look at a 30-year, fixed-rate loan of $100,000 at 6.25% in comparison to a 15-year fixed-rate mortgage at 4% (the average rate in late 2011).
|6.25% 30-year||4% 15-year|
|Total Interest at Year 30 and 15||$121,658.19||$33,143.83|
|Overall Interest Savings||$88,514.36|
The second example above is an excellent illustration of how a lower rate and a shorter term can slash overall interest costs.
Adjustable Rate vs. Fixed-Rate Mortgages
Your monthly payments will change as the interest rate changes if you have an adjustable-rate mortgage (ARM). Some homeowners willingly trade-off the uncertainty of their mortgage payment amount in exchange for a rock-bottom rate. Others hate the idea their payments could rise. If you want certainty and have an ARM, consider switching to a fixed-rate mortgage. You also might prefer a fixed-rate mortgage if you think interest rates will be increasing in the future, which they may have to given how low interest rates are today. (This was edited in late 2011, when rates were about 4%.)
Home equity is the difference between the balance owed on a mortgage and the market value of the property. In the refinance business, this is expressed as a percentage known as “loan-to-value” (LTV). For example, if the balance on a loan is $80,000 and the market value of the property is $100,000, then the LTV is 80%. Market value is set by an appraiser. Market value is not the value set by the tax assessor, and the tax assessment value should not be used to estimate the market value.
If you refinance an amount greater than what you owe, you can receive the difference in a cash payment, which is called a cash-out refinancing. Cash-out refinancing can be wise if you need cash to make home improvements or pay for a college education.
However, shifting unsecured debt to secured debt can create a volatile situation. If there is ever a chance that you cannot afford the new (possibly higher) mortgage payment you are now putting yourself at risk of foreclosure. Also, when you take out equity, you own less of your home. It will take time to rebuild your equity. This means that when you sell your home, you will not put as much money in your pocket after the sale.
If you are considering a cash-out refinancing, think about other alternatives as well. You could shop for a home equity loan or home equity line of credit instead. Compare a home equity loan with a cash-out refinancing to see which is a better deal for you.
Three Circumstances Where Refinancing is a Bad Idea
1) Your mortgage is old
In a mortgage, the proportion of a payment credited to the principal of the loan increases each year, while the proportion credited to the interest decreases. Therefore, in the later years of a mortgage, more of a payment applies to principal and helps build equity. By refinancing late in a mortgage, you will restart the amortization process, and most of your monthly payment will be credited to paying interest again and not to building equity.
However, if you refinance to a lower rate and a shorter term, the interest expense may still be in your favor.
2) Your current mortgage has a prepayment penalty
A prepayment penalty is a fee that lenders may charge if you pay off your mortgage loan early, including for refinancing. If you refinance with the same lender, ask whether the prepayment penalty can be waived. Consider the costs of any prepayment penalty against the savings you expect to gain from refinancing. Paying a prepayment penalty will increase the time it will take to break even, when you account for the costs of the refinance and the monthly savings you expect to gain.
3) You plan to move or sell your home in the next few years
The monthly savings gained from lower monthly payments may not exceed the costs of refinancing.
Eligible for Refinance
Lenders consider income and assets, credit score, other debts, the current value of the property, and the amount the borrower wants. If the borrower's credit score has improved, he or she may be able to get a loan at a lower rate. On the other hand, if the borrower's credit score is lower now than when he or she got the current mortgage, he or she may have to pay a higher interest rate on a new loan.
Lenders will look at the amount of the loan, and the value of the home, which is determined from an appraisal. If the LTV ratio does not fall within their lending guidelines, they may not be willing to make a loan, or may offer a loan with less-favorable terms than the existing mortgage.
The home may not be worth as much as what is owed on the mortgage. If this is the case, it could be difficult for you to refinance.
Refinancing fees vary from state to state and lender to lender. It is customary to pay 3 to 6 percent of the outstanding principal in refinancing fees. These expenses are in addition to any prepayment penalties or other costs for paying off any existing mortgages.
The HUD-1, a copy of your settlement cost papers, will outline the refinance costs:
|Application fee||$75 to $300|
|Loan origination fee||0% to 1.5% of the loan principal|
|Points||0% to 3% of the loan principal|
|Appraisal fee||$300 to $700|
|Inspection fee||$175 to $350|
|Attorney review/closing fee||$500 to $1,000|
|Homeowner's insurance||$300 to $1,000|
|FHA, RDS, or VA fees or PMI||FHA = 1.5% plus ½% per year; RDS = 1.75%; VA = 1.25% to 2%; PMI = 0.5% to 1.5%|
|Title search and title insurance||$700 to $900|
|Survey fee||$150 to $400|
|Prepayment penalty||zero to six months' interest payments|
Calculating the Break-Even Point
The Federal Reserve Web site published a helpful Web page on mortgage refinances that includes this table that helps you calculate the break-even point for a mortgage refinance. The example assumes a $200,000, 30-year fixed-rate mortgage at 5% and a current loan at 6%. The fees for the new loan are $2,500, paid in cash at closing.
|Current monthly mortgage payment||$1,199|
|Subtract new monthly payment||-$1,073|
| Subtract your tax rate from 1 |
(e.g. 1 - 0.28 = 0.72)
|Multiply monthly savings by your after-tax rate||126x0.72|
|Total of new loan's fees and closing costs||$2,500|
|Divide total costs by monthly after-tax savings||$2,500/91|
|Number of months it will take to recover refinancing costs||27 months|
You may also want to compare the equity build-up in both loans. If you have had your current loan for a while, more of your payment goes to principal, helping you build equity. If your new loan has a term that is longer than the remaining term on your existing mortgage, less of the early payments will go to principal, slowing down the equity build-up in your home.