Refinancing Your Home Loan

Perhaps you are carrying a high interest rate on your home loan or you need an infusion of cash.  Either way, you might have been thinking about refinancing, but you're not quite sure.  As you decide, you may want to keep the following considerations in mind. 

What does refinancing involve?

When you refinance, your existing home loan is paid off and replaced with a new one.  Your new loan can be equal to the balance you owe or more than the balance owed.  If it's more, you do a cash-out refinancing, in which case you pocket the difference between the amount owed and the amount borrowed.  No matter which option you choose, you will need to qualify for the loan, going through an application and approval process just as you did when you got your existing loan.  In addition, unless you find a suitable no cost refinancing program, you will incur closing costs.

What are some reasons for refinancing?

One of the more obvious reasons for refinancing is to save money.  For instance, a lower interest rate than the one you have can save you money over the long-term.  Other reasons include:

  • Replacing an adjustable rate mortgage with one that has a fixed rate to avoid the risk of fluctuating, and potentially higher, future rates
  • Getting a shorter loan term to reduce total interest paid and to build equity faster
  • Cashing out some of the equity in your home to cover big ticket items like college education and major home improvements

When is refinancing worth it?

Whether or not refinancing makes sense for you depends on factors such as potential savings, up-front costs, and length of time you plan to stay in your home.  Simply stated, you need to look at how long it will take you to realize savings from the refinance.  If your plans involve moving before you recover the costs and the savings begin, then refinancing might not be the way to go.   Here is a quick example: 

  • Costs to refinance your loan = $1500
  • Reduction in your monthly payments = $50
  • Time required to break even on costs = 30 months (2.5 years)

So, if you plan to move in 2 years (24 months), then you would not have time to realize savings.  If staying for 3-5 years, you would.

What should you pay particular attention to?

Here are a few tips to help you make the most of your refinancing experience:

  • Do your homework.  Treat your refinancing just as you would first-time financing.  Find out what options are available so that you can determine which one is best suited for you.
  • Shop around.  Don't assume that your current lender has the best deal.  Look at interest rates and loan terms offered by other lenders also.
  • Do the math.  Figure out how long it will take you to break even on costs.  You will find calculators and worksheets online that can help you work through this quickly and easily.
  • Watch out for private mortgage insurance (PMI).  If you borrow more than 80 percent of your home's value, you could end up paying PMI.  This protects the lender against financial loss if you don't repay your loan.

When to Refinance your Home?

There are two reasons for refinancing: To obtain extra cash from equity, or to lower payments by taking advantage of lower interest rates. In either case, refinancing can offer tremendous advantages.

However, there are also some risks involved, and before signing on the dotted line, there are a few things to consider. First of all, don't succumb to pressure. There are some unscrupulous mortgage lenders out there who take advantage. In particular, beware of door-to-door contractors who offer to do work on your home, saying that they have "arrangements" with a finance company. Those arrangements are typically usurious. Deal with reputable companies, and do some research on them before making a deal.

Once you have found a reputable financial institution to handle your refinance, take a careful look at what fees are involved. It's true that refinancing can cut your interest payments, sometimes significantly -- but there may be points and other fees involved. If you are adept at math, you can easily calculate a break-even point to determine what level of fees are acceptable. The total amount of fees should be less than the total savings you will realize over the duration of the time you expect to continue living in your home. If you plan on staying in your home for the rest of your life, it may be worthwhile to refinance, even if you have to pay some high up-front fees. On the other hand, if you are planning to move in five years, those high up-front fees may well eliminate all the savings in interest you would see during that five-year period.

Generally, you can save money if your current interest rate is at least two points above what you can get on a refinance deal. When considering any type of major financial transaction, it is always advisable to compare offerings from several different financial institutions. However, the mortgage company that holds your existing mortgage would be the best place to start when looking to refinance. There are some considerable expenses involved in refinancing, but if you refinance through the same company you used for your original mortgage, you may be able to save on some of those expenses and closing costs.

Cash out refinance
A "cash out" refinance lets you cash in on some of the equity in your home to get needed cash for expenses such as college tuition or home renovations. Since this will leave you owing more than before, it is likely that your mortgage payments will increase, and you will also have to pay up-front fees. Carefully factor these things into your calculations before deciding on a cash out refinance, and make sure the new mortgage payment will be affordable. If your original mortgage carries a very high rate of interest, and your refinance will offer a significantly lower rate, it may be possible for you to get cash out and still be left with the same monthly payment.

Finally, the tax ramifications must be considered. Mortgage interest is deductible, but only up to the value of the home. If you take advantage of one of the more esoteric products that allow you to borrow 110% or 125% of the value of your home, you will only get to deduct interest on the portion of your mortgage that is equal to your home's value.

Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.