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Refinancing a mortgage happens when a borrower pays off the balance of his existing loan and takes out a new loan in its place. Many homeowners resort to this practice for a variety of reasons.
Refinancing could help them take advantage of a lower interest rate, reduce or lengthen the repayment period, convert from an adjustable-rate mortgage (ARM) to a fixed rate mortgage (or vice versa), leverage home equity to purchase a more expensive property, or plainly to just consolidate all debts.
All of these objectives have their own merits and drawbacks. Since refinancing a mortgage can cost anywhere from 2.5% to 5% of the loan principal and would entail repeating the entire process of appraisal, title search and payment of application fees, homeowners should be discerning.
It is very crucial to evaluate whether refinancing will really be advantageous for the homeowner in relation to his or her situation.
Mortgage refinancing is a wise recourse under many circumstances.
Here are some of them:
Mortgage Rates Have Dipped
The primary motivation to refinance is to lower or lessen interest cost. This is why most of us refinance not just mortgages but just about any loan that qualifies for that option – auto loans, student loans, or even credit card obligations. No less than the White House mentioned that the average homeowner could save around $3,000 per annum by refinancing their homes.
As you consider whether the lower rates would justify refinancing, carefully take note of the following facts:
- While mortgage rates have gone down, predicting future interest rates with utmost certainty is a fantasy. Most analysts have predicted that rates will go up in the coming months. I believe their predictions. I also believed that the Cleveland Indians would win the 2016 World Series. My point is, make a decision whether or not to refinance based on today’s prevailing rates and not on a prediction of future trends.
- Your potential savings on the new loan do not depend on the interest rates alone. Mortgage brokers will predictably pitch the lower monthly payment but remember that your monthly payment will also depend on the term of the new loan. If you have 20 years remaining on your old mortgage and refinance it back to a 30-year term, your monthly payment will be lower even at the same interest rate.
- It is also important to consider the tax implication of a refinance. While it may be true that a lower interest rate would lower your monthly interest expense, it would also decrease your tax deductions and effectively increase your taxable income. The monthly savings then could be insignificant when the tax liability is taken into account.
Refinance to Reduce The Term of Your Loan
If the original term of your loan is 30 years, it might be a wise decision to refinance now. With the present low interest rates, a new 15-year mortgage is not much more expensive than the 30-year mortgage you have been paying off.
Use a mortgage calculator to determine what the new payment would be. If the new estimated payment is reasonable, consider getting in touch with your bank or mortgage broker.
Refinance to Switch from a Flexible to a Fixed Mortgage Rate
The low-interest rates will not be here forever so locking in to a lower rate now is your protection when rates do escalate in the coming years. Moreover, it is easier to budget and plan for a fixed payment.
Overview Of Refinancing Process
So now you may be asking: “How much lower must rates be to justify refinancing?”.
You will find a number of conventions on this, ranging from 0.50% to 2%. A more conservative approach is to do the actual math. All it takes is a few steps.
1. Determine the amount you will save in monthly interest. The actual amount will go down as you pay off your mortgage but for a quick estimate, the first month’s savings will do.
2. Reduce the interest savings by your marginal tax rate to reflect the smaller tax deductions. Do this only if you itemize your deductions.
3. Determine the total refinancing cost of your mortgage. Your bank or broker would likely have this information in your account file.
4. Lastly, divide the total refinancing cost of your mortgage by your monthly after-tax savings. The resulting figure denotes the number of months it will take you to reach the breakeven point. If you are planning to stay in that house longer than the time to breakeven, then refinancing is a sensible choice. With these steps, you can see why it is better to focus on the total refinancing cost than just on the interest rate.
Should You Refinance to Decrease Your Monthly Payments?
Decreasing your monthly payments will definitely create a positive impact on your budget.
But before you decide if refinancing is for you, check out some of these details:
1. Potential Benefits of Lower Monthly Payments
Lowering your monthly loan payments through refinancing (either by getting a lower interest rate or by extending the term) can make it easier for you to pay your mortgage on time every month and possibly provide enough surplus funds to service other debts and expenses.
Also, if you are apprehensive about your capacity to pay the current monthly level in the future, lowering your monthly payments will help relieve you of the anticipated financial pressure.
2. Refinancing Costs
When you refinance, you will be paying for closing costs. Additionally, the common practice would be to refinance for the same term as the original loan. This means starting another 30-year loan after a lapse of so many years off the original term on a home that you already own.
In effect, you’ll be paying more in terms of aggregate interest over the total life of the loan. While the monthly mortgage payment would appear to go down, your total cost over the entire term would likely go up. It’s vital that you talk to your lender about your situation and make sure that you will be comfortable with how these costs will play out in your overall financial situation.
3. Your Mortgage Breakeven Point
The breakeven point is that moment in the term of the loan when the total reduction in your monthly payment becomes equivalent to your total financing costs. If you have plans of selling your home in the future, you probably would not recover your closing costs if you sell it before reaching the breakeven point.
Here is a sample computation of breakeven point:
$5,000 in total closing costs ÷ $200 in monthly payment savings = 25 months (to break even)
4. Your Credit Score Has Improved
Even if interest rates don’t go down, you may still qualify for a lower rate if your credit score has gone up. According to my FICO, current mortgage rates may vary as much as 1.70% depending on a person’s credit score. This means for a $250,000 mortgage, an incremental 1.70% interest due to a mediocre credit score will impose an additional $250 on your monthly mortgage payment. Read our article on the best ways to get your credit score