Mortgage
refinancing basics
Your mortgage may have a 30-year
term, but not many homeowners stay with the same loan for that
long. In fact, the average American refinances his or her
mortgage every four years, according to the Mortgage Bankers
Association. That’s because paying off your present mortgage
and taking out a new one can mean big savings over several
years. However, refinancing comes with a price in the short
term, so it’s important to consider both the costs and
benefits before making your decision.
Why refinance?
Here are some reasons to consider refinancing your mortgage:
- To obtain a lower fixed
rate. If you took out a fixed-rate mortgage several
years ago and interest rates have since dropped, refinancing
may lower your payments considerably. A $150,000 mortgage
with a 30-year term and a rate of 8 percent, for example,
carries a monthly payment of $1,100. The same mortgage at 6
percent will have a payment of less than $900 a month.
- To switch to a fixed rate
or an adjustable rate mortgage. Adjustable-rate
mortgages (ARMs) offer lower interest rates initially, but
some homeowners find the fluctuations stressful. If rates
are on the way up, you might consider locking in at a fixed
rate and consistent monthly payment. On the other hand, if
you want to reduce your monthly payments and are comfortable
with the interest rate changes of an ARM, it could save you
money to refinance to an ARM.
- To improve the features of
your ARM. Mortgages with adjustable rates have
protective caps that limit how much your payments can
increase in any given year and over the full term of the
loan. You may be dissatisfied with the caps on your current
ARM and feel you can negotiate more favorable features if
you refinance.
- To build your home equity
faster. If a recent change in your financial
situation has made it possible for you increase your monthly
payments, you might want to refinance your mortgage with a
shorter term. The higher payments will enable you to pay off
your home more quickly and to save substantially on
long-term interest charges. However, if you are disciplined
you can also opt not to refinance and simply pay more
towards your principal each month.
- To reduce your monthly
payments. Refinancing for a longer term will lower
the amount you have to pay each month. You will end up
paying more in interest charges over the life of your loan,
but if you’re having difficulty making your current
payments, this strategy could provide some relief.
- To turn home equity into
cash. You may want to take out a new mortgage with a
larger principal, in order to turn some of your home equity
into cash for a major expense. This is called cash-out
refinancing. The advantage of taking out a loan secured by
your home is that you can get a lower rate of interest than
you can with an unsecured loan or credit card. However, if
the interest rate offered for your refinanced mortgage is
higher than your current rate, a home equity loan or line of
credit might be a better choice.
Is refinancing right for you?
If you’re refinancing in order to pay less interest, you
won’t usually see the savings right away. That’s because
lenders typically charge fees when you take out a new mortgage,
and you may also have to pay a penalty for getting out of your
old one. To determine whether refinancing makes financial sense
for you, consider these issues:
- How long you plan to be in
your home. If you expect to move in a year or two,
you may never realize the potential savings you’d get from
refinancing. As a rule of thumb, the longer you plan to stay
in your current home, the more sense it makes to refinance.
- The prepayment penalty on
your current mortgage. Many mortgages carry a penalty
if you pay them off early. The amount varies, but it is
usually a small percentage of the outstanding balance, or
several months?worth of interest payments.
- The costs of the new
mortgage. When you take out a new loan, your lender
may charge a number of fees including application,
appraisal, origination and insurance fees, plus title
search, insurance and legal costs that can add up to
thousands of dollars. Lenders may also charge discount
points, [pop-up link to glossary term] which are paid
upfront to secure a lower interest rate. As a guideline,
expect fees to eat up any potential savings unless your new
interest rate is at least a half a percentage point lower
than your current one.
- The true difference in
borrowing costs. When you’re considering
refinancing, remember that the posted interest rate
doesn’t reflect the entire cost of the mortgage. The
amount you pay over the life of the loan will also be
affected by the length of the term, whether your rate is
adjustable or fixed, whether you paid discount points, and
what upfront and ongoing fees you incur. One way to compare
mortgage costs is to look at the annual percentage rate
(APR), which takes into account not only the base interest
rate, but also points and other charges. All lenders must
follow the same rules when calculating the APR, so it’s a
good basis for comparison.
- Your reduced tax savings. If
you claim mortgage interest on your tax return, refinancing
to a lower rate will mean that you’ll have less mortgage
interest to deduct. You will still save money overall, but
your real savings from refinancing may not be as large as
you first believed. Consult a tax advisor who can help you
understand the tax implications of refinancing.
The break-even point
In the end, deciding whether the cost of refinancing is worth it
comes down to a simple question: “How long will it take before
I start to save money??In theory, this is a simple
calculation. You start with the amount you will save by lowering
your monthly payment. Then you add up all the costs associated
with refinancing and divide the total by your monthly savings.
This will reveal the number of months it will take to reach the
break-even point.
For example, let’s assume that refinancing would lower your
payment from $1,000 to $800 (for a savings of $200 per month)
and your prepayment penalty, closing costs and points add up to
$5,000. Divide $5,000 by $200 and you’ll see that it would
take 25 months to realize the savings.
In reality, however, your break-even point also depends on other
factors, including your tax situation and whether you pay
closing costs upfront or add them to the principal of your new
mortgage. If you are refinancing and your home has appreciated
in value, you may also be able to save by canceling your private
mortgage insurance.
For a more accurate estimate, use our refinancing calculator. Or
consult a financial advisor who is familiar with your tax
situation.
Start your refinance request now and get Lenders to compete
for your business.
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