For many homeowners, the concept of refinancing the home mortgage may seem very appealing and just the answer in these times of economic turmoil. After all, who would not want the ease of lower monthly payments, the security of a fixed rate loan, or better yet, the thought of freeing up some extra cash for that much needed college education savings, new car, or home renovation?
Indeed, there can be so many reasons why a “refi” would be an attractive option for cash-strapped and financially distraught consumers. What many people fail to recognize however, is the reality that home refinancing is in fact, not a sensible move for everyone. While the numbers at a glance may appear promising, e.g. an interest reduction of 2%, there are still other factors to be considered.
That is why it is crucial that before any decision is made on a refi, all the bases of this not-so-simple and possibly lifestyle-changing transaction should have been covered.
Why Opt for Refinancing?
The practicality of the option of refinancing varies from one individual to another. There are a few basic factors wherein refinancing would be the wiser move:
1. Lower interest, lower monthly payments
The arbitrary rule of thumb says that refinancing would only be logical if you can avail of an interest rate that is lower by at least two percentage points, say 8% to 6% for instance. However, the key factor to consider is whether you plan on staying in your home for a longer period of time – enough to make your savings from the monthly payments make up for the costs incurred in refinancing.
Take this scenario: If you had a $180,000 360-month mortgage with an 8% interest rate, your monthly payment would be about $1,321. If you refinanced at a lower rate of 6%, your new monthly payment would now amount to $1,080, or a savings of $241 per month. Assuming that your new closing costs totaled about $1,800, it would take eight months for you to break even ($241 x 8 = $1,928). If you had no plans of moving out and selling your home within that period of time, a refi would be quite suitable in this case. Otherwise, don’t bother with refinancing at all.
2. To take cash out of your home’s equity.
The monthly amortization you pay each month increases the equity you have in your house. This equity can actually be considered as a considerable part of your savings. If you choose to have your home loan refinanced, you will be able to free up some of this money to use for other projects such as setting aside some amount for your child’s college education.
Another good reason to convert some of your home’s equity to cash is to pay off debts that have non-deductible interest costs. The interest on most home loans is tax-deductible, which means that if you have a substantial amount of debt in non-deductible loans like in credit cards and car loans, using part of your equity money to pay these debts off would be a smart thing to do as the interest you pay for all debts combined would now be tax-deductible.
3. To save on interest costs depending on the variable factors
An important thing to keep in mind when considering home refinancing is, it is not only the interest rate that counts in the big picture, but all other aspects of the mortgage that may be changed to suit your needs for the moment or your future plans.
Term of the Mortgage
One of these factors that would impact on the bottom line savings is the term of the mortgage or the length of time it would take a homeowner to pay off the loan’s principal amount and interest. In general, a long-term mortgage always has a higher interest rate, although one would only be required lower monthly payments. A short-term loan on the other hand, comes with a lower interest rate and higher monthly amortizations. Simply put, the long-term mortgage allows you the ease of more affordable monthly payments, while the short-term loan will give you the bigger interest savings, provided of course that you can keep up with the monthly cash outlay.
Refinancing to change to a long-term fixed rate loan from an ARM or vice-versa
For those who would want to avail of short term savings, an adjustable rate mortgage (ARM) is a good way to get into a home with low monthly payments. The downside of course, is that this type of loan undergoes periodic rate adjustments and is susceptible to rate hikes, that when the term is up (like one year for example) you might be in for an unpleasant surprise when given a much higher rate. Thus, for homeowners who see themselves living in their homes for a good number of years or even until retirement, a long-term fixed rate loan is the most practical option.
During these times when mortgage loans are at their lowest with some fixed 30-year loans at 6%, changing to a long-term fixed rate loan may well be the answer to having some security and control over your future financial situation.
Points, also called discount fees or origination fees, are the fees that are paid to the lender upon closing of the loan. Each point equals 1% of the loan, e.g. for a loan of $180,000, one point is equal to $1,800.
The deal with many loans is you can actually have your rate decreased by paying more points. On the contrary, a “no-cost” or “zero points” mortgage does not require this upfront cost, but the lender charges a higher interest rate instead. If you have some extra cash on hand, using points is a good way of saving money on interest over the course of your mortgage. If you’re low on upfront cash however, then you would have no choice but to opt for fewer points with a corresponding higher interest rate.
Whatever alternative you decide on, do the maths and determine if the savings from a lower rate justify the amount that you would have to shell out from paying more points.
Reading the Fine Print
Thinking of having your mortgage refinanced? Yes, this may seem like the chance to give your monthly budget some breather. However, do not let yourself be lured by the seemingly attractive offers that many lenders will no doubt attempt to entice you with.
So before affixing your signature on that line:
• Remember that you always have a choice so shop around for the best rates, offers or deals.
• Make informed decisions rather than allowing yourself to be intimidated into doing something that you have not fully understood.
• Do not be afraid to ask questions as there may be some stipulations that are not obviously stated but you need to know.
• Do some serious number crunching first.
Simply put, the end goal of home refinancing is that the savings that can be had from refinancing one’s home should far outweigh the costs that come with it.