Clearly, the new historically low interest rates offer many, if not most, homeowners an opportunity to refinance mortgages. If you are considering refinancing, make sure you have clear goals about what you want to accomplish because this opportunity isn’t likely to come around again during your lifetime. Generally, refinancing is done to accomplish one of three goals.
You can also look at a combination of all three goals although that option is available to fewer people. Combination opportunities are mostly available to people with a substantial amount of equity. For instance, if your main goal is lowering the monthly payment, that is difficult to combine with shortening the length of the loan or taking out cash if don’t have much equity.
However, if you’re comfortable with your monthly payment remaining relatively unchanged or going up slightly, you could take out cash and shorten the length of your loan. For instance, you could switch from a 30-year fixed mortgage to a 20-year fixed mortgage while taking out cash at the same time. Of course, 15-year and 10-year mortgages are also possibilities.
The key components to how much your monthly payment changes are the total amount that you borrow, the new interest rate, the length of the loan, and the cost of refinancing. Don’t forget the cost of refinancing because this does add up. Another important consideration is how long you plan to continue owning the home. These scenarios make the most sense if you plan to stay in the house long term. Rarely do these make good financial sense if you’ll be selling the house within the next few years.
There are also ways to shorten the length of your loan and lower total monthly consumer payments. For instance, it might be possible to shorten the length of the loan, take cash out, and us the cash to pay off a car loan. That effectively lowers the total amount you are paying out each month. Many creative financial solutions are possible when refinancing.
Consider why lenders willingly offer to refinance at lower interest rates. There has to be something in it for them. Otherwise, they would prefer keeping your loan at a higher interest rate to make more money. Where lenders are making money is from the refinance costs. Generally, you will be paying closing costs all over again. You’ll be paying an application fee, appraisal fee, inspection fee, title insurance, discount fees, administrative fees, and other assorted fees. Always look carefully at the loan estimate and compare costs from multiple lenders. On average, refinance closing costs range from 3% to 6% of your loan amount.
Even before you begin filling out applications, get comfortable using a mortgage calculator to run multiple scenarios. If you are only trying to lower your monthly payment, mortgage and refinancing calculators are pretty straightforward to use. You simply put in your current mortgage information and your new mortgage information (including the costs for refinancing). You then compare your existing payment to your old payment. Something important to be aware of is that you are probably resetting the length of time you’ll be paying on the mortgage to start again at 30 years. Your monthly payment will go down but ultimately you’ll be making monthly payments for several more years. If you’ve been paying for 7 years, you only have 23 years remaining on the mortgage. Refinancing to a new 30-year mortgage resets the loan length to 30 years. That’s why it is a good idea to consider 20- and 15-year mortgages when you refinance.
If you want to lower the amount of interest you’ll ultimately pay on the loan, you use the amortization schedules from both your current loan and the loan you are considering. Pay particular attention to the interest paid column. What’s important is that as you pay off the loan each month, you pay less in interest and more against the principal each month. For your current loan, locate next month’s payment. If you’ve been paying on the loan for 5 years, this will be payment number 60. Add up all of the remaining interest payments. For the new loan, add up all of the interest payments for the entire loan. For the new loan, also add in the financing costs from the loan estimate. The difference between the two tells you how much refinancing will save you or cost you. You can use this same basic math technique if you are planning to sell the house before you pay off the mortgage. Do this by adding up the interest for the number of months you plan to keep the house. If it is 5 years, add up the next 60 months’ worth of interest payments for the current loan and compare it to the first 60 months of interest on the new loan (again, include the refinancing costs).
Too many people fail to see all of the opportunities that refinancing provides. There are many more possible financial solutions than described here. Generally, if you can save money, build equity faster, and/or pay off your mortgage faster, refinancing is a good decision. With the recent interest rate drops, even people who have fairly new mortgages may be able to benefit from refinancing. What you are mostly looking for is the cumulative savings on monthly payments that are enough to offset the costs of refinancing. With today’s interest rates, you may come out ahead by refinancing even if you’ll only be paying on the mortgage for another 18 months or 2 years.
What tips can you offer for people considering refinancing? Please leave a comment. Also, our weekly Ask Brian column welcomes questions from readers of all experience levels with residential real estate. Please email your questions, inquiries, or article ideas to [email protected].