Refinancing (Part II)
Why do people refinance? All for different reasons, of course, but the most common ones are:
- To obtain a lower interest rate,
- To build the equity of their property faster,
- To change the type of their loan,
- To take advantage of an improved credit rating,
- To get some cash out of the equity already built in the home.
How does it work?
Obtaining a lower interest rate is probably the most popular reason to refinance. One may have an adjustable rate mortgage with a rate gone too high, or a high-rate mortgage resulting from negative points, or an above-the-average rate caused by the poor credit score at the time of the loan origination, or it may have been a very sensible loan all the way until mortgage market interest rates dropped. Refinancing in such and such like situations can save you quite some money, but you have to be very thorough in estimating the benefit. The main question is whether the amount saved will be worth the amount paid. The procedure of refinancing is not cheap, so you have to make sure, that the money you pay for it will not only return to you, but also gain you some profit as savings on the interest, as compared with your current loan.
One of the decisive factors is the length of the remaining term of your current loan and the term of the probable new one. If the former is short, refinancing will make little sense as there will hardly be any loan that will pay off in a better way than the existing one. If the latter is too short, there will not be enough time for any real benefit to occur. Generally, there is little, if any sense, in fiddling with refinancing short term mortgages, unless the current mortgage is a total killer.
Refinancing to a shorter-termed mortgage can, however, help you build the equity of your property faster. The interest rate of a shorter-term mortgage will most likely be lower, so you will actually own more of your home every year and at a lower price. Which is good, if you can afford it, because even though the interest rate is lower, the monthly payments may well become higher, if the new term is shorter than the remaining years of the current loan: the amount of your remaining balance will have to be distributed throughout a shorter period of time. If higher monthly payments do not bother you, you may also consider regular extra principal payments to your existing mortgage as an alternative. Depending on your situation, you may be better off with just the extra payments, avoiding the trouble and the expense of refinancing altogether. Use this refinancing calculator and this extra payment calculator to compare the options. The lower interest rate of a new mortgage will cut down the amount you can deduct from taxes as interest payments; extra principal payments to the existing loan have an indirect effect on the tax deductible amount - as the balance of the loan goes down faster, the amount paid towards interest (a percentage of the remaining balance) decreases faster, too. This latter decrease, however, usually compensates for whatever tax deductions. These are my general considerations, though, meant to draw your attention to the issue. The calculators mentioned above give you a concrete idea of the tax consequences.
Some homeowners prefer to refinance their adjustable rate mortgage to a fixed rate mortgage when interest rates fall. A lot of people take out adjustable rate mortgages during periods of high interest rates because the rates of the early years of adjustable rate mortgages are lower. The rates adjusted later, however, can become pretty high, and if there happens to be an overall drop in mortgage interest rates, it may become advantageous to switch to a fixed rate mortgage. Catch the right moment to refinance and enjoy the stability and comfortable predictability of a fixed rate mortgage.
If you are refinancing to get a loan that recognizes your improved credit status, you may want to call a credit bureau to get a copy of your credit report and make sure everything is reported correctly, before visiting a lender.
If you have owned your home for quite some time, you may have accumulated a considerable amount of equity in the property, which allows you to refinance your existing mortgage to an amount actually higher than the remaining balance of your current mortgage. As the amount of the new loan is bigger than your debt on the current one, you will have enough funds to pay off the mortgage you have now and still more to use for, say, your children’s education, or home improvements, or to repay other debts. “Cash-out” refinancing normally allows you to re-mortgage up to 90% of your property value. If, for instance, the value of your home is $200,000 and the current balance of your mortgage is $100,000, you can refinance to an amount equal to 90% of $200,000, i.e. to $180,000 and use $100,000 to repay the old mortgage. The remaining $80,000 cash can be used for whatever purpose you will find for it, and it’d better be a good one for the price. Which is..? Well, first of all, after all the years of repaying your debt and building equity in your home, you are going to lose most of it and start all over. A lot of people find it hard, as owing the place you live in does give you this secure feeling of home, sweet home. It is a kind of hard to wake up in the morning and realize that today it actually is not as much yours as it was yesterday. Moreover, apart from all the regular refinancing fees, you may have to face such additional monthly payments as PMI premiums. If over 80% of the home value gets to be mortgaged, it triggers the obligatory PMI. If over 90% of the property is mortgaged the conditions can be highly unfavourable, so do not rush into such offers, no matter how easy the broker makes them sound. Don’t let anyone talk you out of your home. Always compare different offers, gather and study all the relevant information thoroughly before you agree to sign. Remember, this money is not a gift; it is your big debt that you will have to be repaying from the day on.
If the purpose of your refinancing is mainly raising some cash, you may also consider taking out a second loan of some sort instead, or refinancing into a Piggyback loan to avoid PMI. However, when you compare these two-loan options with “one-to-one” cash-out refinancing, don’t forget to take the non-financial issue into account, too. Even if the maths of the deal makes the second or the piggyback loan more attractive, there are still a couple of non-numeral variables in the equation: having a second mortgage (even a piggyback version of it) makes it practically impossible for you to qualify for any other loan should a need for it arise; the lack of proper subordination arrangement for the second loan may make it impossible for you to refinance the first loan later.
A separate big issue is prepayment penalties on both the old mortgage and the new one. As refinancing means paying off your current mortgage before its original term is over, you may have to face a penalty for the early repayment. It is not always the case, though. You have to check your contract and every supplementary note that comes with it, and see if you are in for the penalty on the day you are planning to refinance. With most lenders the prepayment penalty applies only to the first several years of a mortgage and will probably cause no problem at a more advanced stage. Penalties on the new mortgage can be rather painful, especially if you are refinancing into a mortgage, whose other terms are not exactly very friendly either. Sometimes circumstances make people go for such loans, but everyone wants to get rid of them as soon as possible, so make sure that your new contract will not include anything that may hinder you from doing so at the time you are ready.
