Refinancing. Is a personal financial decision.
The decision to do it should be made using long-term thinking.
What are the circumstances to when you should refinance and how do you do it?
There are many different reasons for refinancing your current mortgage. Most of them have to do with lowering your current payment, but let’s dive into some of those reasons to find out specifics.
- Lower interest rate - You refinance to get a lower interest rate. For example, you bought your house in a higher rate environment and pay 8% interest. Now the interest rates are 4%, so you refinance to get that lower rate.
- Shorter-term - If you have a conventional 30-year loan, you might want to reduce your term to 15 years instead. This type of move usually works in conjunction with a lower interest rate. For example, you have a 30-year 9% fixed rate $200,000 mortgage. Your monthly payment in this scenario would be $1,609.25. Interest rates fell to 5% and you want to refinance, but you don’t want to be stuck with another 30-year payment so you reduce the term to 15. Your new monthly payment for the new $200,000 mortgage would be $1,581.59. Conversely, if we were to use the same interest rate, 9%, for 15 years, that payment would be $2,028.53.
- Change rate type- There are three different types of rates: Adjustable, variable, and fixed. With an adjustable rate, as the interest rate changes, so does the monthly payment. If interest rates go up, so does your monthly payment. Same goes if the rate goes down. With a variable rate, the monthly payment stays the same whether the interest rate goes up or down. For example, if rates go down, more money will be paid towards the principal, but if rates go up, more money will go towards the interest. A fixed-rate mortgage stays the same for the entirety of the loan and so does the monthly payment.
- Cash-out refinancing - You borrow more than your previous loan and use the cash (the difference between the old loan the new one) to pay down other debts. A few things to keep in mind when doing this.
- You borrowed more for another 30-year period, so you will pay more in interest.
- With regard to credit cards, you are moving from unsecured to secured debt. Why does that matter? For example, if you fail to make payments on your credit cards, you’ll get sent to collections and damage your credit score. However, if you fail to make payments on your mortgage, those creditors can take your house!
- Credit score went up - An improved credit score, generally means that you will be eligible for better interest rates. This isn’t always the case, though, so make sure you shop first.
- You need a lower payment - Plain and simple, you can’t afford your current payments. If you have been in the house for 5+ years, have chipped away at the loan and have a bit of equity, you can use that equity as your “down payment,” and borrow less money for a 30-year term. All else being equal, this will decrease your monthly payment.
Use a mortgage refinance calculator
Crunch the numbers. Figure out how much, if any money you’ll save by refinancing. I’ve linked to a mortgage refinance calculator from Bankrate.com. I suggest working the numbers before you make any decisions.
Different lenders are going to offer you different rates. Each place uses their own system. What’s more, each lender will have different fees (more on that below). Do yourself a favor, shop around, get the best deal.
Get finances organized
Lenders won’t give you the light of day if your financial life is a mess. This is just like your original mortgage application. Make sure your income is steady, make sure your debt to income ratio isn’t out of whack, make sure you have money saved for emergencies.
As most homeowners know, owning a home costs much more than a mortgage plus utilities.
Know the costs
The fees and costs associated with buying a home are the same fees and costs as when you refinance, with the exception to the one at the bottom.
- Application fee
- Appraisal fee
- Origination fee
- Document processing fee
- Underwriting fee
- Title and research fee
- Recording fee
- Tax transfer fee
- Closing costs
- Higher interest costs
As most of you should know, at least you should know if you are a homeowner, mortgages are amortized. This means that at the beginning of the loan, most of your payment is going towards the interest, with very little hitting the principal.
As time goes on, more and more will be paid toward the principal and less towards interest.
For example, if you’ve had a mortgage for 10 years and now decide it’s time to refinance, it’s going to cost you a lot more money in interest. For the past 10 years, the vast majority of your payment went towards the interest, and you are getting close to the point where the majority of your payment goes towards the principal.
Refinancing your mortgage makes you start all over. More money will be spent on interest and in the long-term, will cost you more money.
I’ve written about this topic before, so I’m going to link to it. You can find that article, here.
When and how to refinance is a personal choice. Whether it’s to reduce your payment, reduce your term, or some other reason, it’s important to know the ins and outs of refinancing so you make the right decision.