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Refinancing mortgages: The full breakdown

At a glance:

  • When to refinance a mortgage

  • Types of mortgage refinancing available

  • The costs of refinancing

  • The disadvantages of mortgage refinancing

  • Summary of refinancing mortgages

One of the features of many mortgages is the opportunity to rework the loans so that you can pay less interest in the future. The potential savings can make refinancing very worthwhile in many cases.

There are many reasons persons refinance their mortgages. Sometimes it is just to get equity out of their homes. At other times it is to lower their payments, or to get a lower interest rate. However, refinancing is not without cost, and cost needs to be considered when refinancing.

The decision to refinance should be part of an overall financial plan that weighs the advantages and disadvantages of refinancing in light of your future financial goals.

When to refinance a mortgage

When mortgage interest rates drop more than a percentage or so, some homeowners will decide to refinance their loans to get a better rate.

Consider that average interest rates on fixed-rate mortgages have ranged from more than 15 percent in the early 1980s to less than 4 percent after the year 2000, and you can see that refinancing can result in significant savings for the homeowner.

When to refinance?

A general rule of thumb is to refinance when interest rates drop 2 percentage points or more. For example, if you have a $100,000, 30-year, fixed-rate mortgage at 10 percent, you will pay more than $215,000 in interest over the next 30 years.

But if you have a $100,000, 30-year, fixed-rate mortgage at 8 percent, you will pay less than $165,000 in interest over the same period.

When a smaller drop in rates makes sense to refinance

The two percent rule makes sense in many cases; however, sometimes it makes sense to refinance even when interest rates drop only 1.5 percent or even 1 percent.

Homeowners who plan to keep their homes for many years may still profit from refinancing when interest rates drop less than 2 percent, since they will have many years to recoup the costs associated with establishing a new mortgage loan. Another general rule is to refinance when your interest savings will cover all loan costs in two years or less.

Reducing your monthly mortgage payments

Many homeowners refinance to reduce their monthly mortgage payments. If you have built up equity in your home, you also may want to consider replacing your old mortgage with a larger loan, pulling out some of the equity you've built up as cash for debt consolidation or other purposes.

Or, you may want to use the savings in interest to reduce the length of your mortgage. For example, a $100,000, 15-year, fixed-rate mortgage at 8 percent will cost you less than $75,000 in interest over the next 15 years—compared to $165,000 for a 30-year mortgage.

Another way to reduce the mortgage term is to make extra payments whenever possible. You also sometimes can establish a twice-monthly payment plan with the mortgage lender to shorten the mortgage term.

Using a fixed-rate mortgage

If you have an adjustable rate mortgage (ARM) and interest rates seem to be rising, you might consider replacing your ARM with a fixed-rate mortgage. Some people prefer the security of knowing precisely what their mortgage interest will be, rather than worrying about whether—or how much—it may go up in the future.

There are many reasons to refinance a mortgage. You should evaluate the financial impact of refinancing as part of a sound financial planning strategy.

Types of mortgage refinance available

You may want to convert an adjustable-rate mortgage (ARM) to a fixed-rate loan to gain stability in your monthly payments or in the event that interest rates drop faster than your ARM can accommodate. Many ARMs have caps limiting the amount of periodic adjustments.

So, if interest rates drop 3 percentage points in a year but your ARM has a 2 percent annual cap, you may want to refinance to take full advantage of the new, low interest rates.

When interest rates drop

When interest rates drop, you can refinance to take advantage of the new rates, getting either a new ARM or a fixed-rate mortgage at a lower rate. When you replace an old ARM with a new one, you generally reset your mortgage's lifetime adjustment cap.

For instance, if your old mortgage had a lifetime adjustment cap of 6 percent and the initial rate was 10 percent, your mortgage rate could go as high as 16 percent. If you replace your old mortgage with an ARM with a rate of 8 percent and a lifetime adjustment cap of 6 percent, your mortgage interest rate will never go higher than 14 percent.

Reducing the interest rate on your loan is usually a good reason to refinance a mortgage. In order to take advantage of new rates by refinancing, however, you sometimes must have a minimum equity of 10 percent in your home.

You can change the term of your loan

Refinancing provides the added opportunity to either reduce or extend the term of your loan. Say you have 20 years left on a 30-year loan at 10 percent interest. You learn that you can get a new, 30-year loan for the outstanding principal at 8 percent interest and save $250 per month on your payments.

But you also learn that you could pay off your loan faster by continuing to pay about the same amount each month on a 15-year mortgage. This latter option could be a good choice in certain circumstances—for example, if you are nearing retirement.

Advantages of a longer term

If you choose to get a new mortgage with a longer term, you may simply be happy making the lower payments each month. On the other hand, you may want to continue your payments at about the same level and take a larger mortgage loan, taking some cash out of the equity you've built in your home.

People take equity from their homes for many reasons; one of the best of these is debt consolidation. When you refinance a mortgage to consolidate credit card debt, for instance, you usually replace high-interest credit card debt with a low-interest mortgage debt.

Beware that some lenders require you to retain at least 25 percent equity in your home when you refinance for debt consolidation.

The costs of refinancing

Like many good things, refinancing a mortgage carries a price tag. Actually, there are several distinct costs associated with refinancing.

The loan origination fee

The loan origination fee is often the largest expense. This fee is expressed in points and is considered upfront interest on the loan. A point equals 1 percent of the principal of the loan. For example, 3 points on a $100,000 mortgage would equal $3,000.

Points are part of the lender's profit and are generally considered in tandem with the interest rate. The two are usually related: the higher the rate, the lower the points, and the lower the rate, the higher the points.

When the points cover more than the origination fee, the additional points are called discount points, which serve to offset the interest rate. Sometimes, you can pay discount points upfront at closing to get a lower interest rate on your mortgage.

As a result, it may take you three or four years—or more—before your interest savings cover all of the loan costs. This may still be a good option if you are planning to keep your home for a number of years.

Other costs

Other costs may include appraisal fees, survey fees, title insurance, termite inspection, and fees to record the loan with appropriate government offices. You also may incur legal costs, since you may want (or your state may require) your attorney to attend the closing.

Basically, refinancing costs usually include the same costs involved in getting your mortgage in the first place. Sometimes, the points and other closing costs can be refinanced as part of the loan package.

About no-cost refinancing

Lenders sometimes offer no-cost refinancing, charging you zero points for your mortgage loan. Generally, you will pay a higher interest rate on a zero-point mortgage than on an otherwise comparable mortgage with points, and you will still have to pay the other costs associated with the loan.

Prepayment penalties

Another cost that sometimes affects refinancing is a prepayment penalty, which lenders occasionally charge. Consult your mortgage agreement to see whether it contains a prepayment penalty, and try to avoid prepayment penalties in any refinanced mortgages. Even if your old mortgage requires a prepayment penalty, refinancing may still make sense, depending on your potential interest savings.

The disadvantages of mortgage refinancing

Besides the costs of refinancing, you may want to consider other potential disadvantages before signing on the dotted line. For example, if you cash out some of the equity in your home, you will own less of your home when the deal is done. And it may take you longer to own your home free and clear than if you had not refinanced.

Take time into consideration

Time is also a consideration when it comes to refinancing costs. How long will it take for your new interest savings to pay off the property appraisal, title insurance, and other costs? You may have to live in the house longer than you planned to make the refinance worthwhile. If you move before you have recouped the refinance costs, you will lose money on the deal.

How long before you break even?

To calculate how long it will take to amortize these costs before you "break even" with your present mortgage, begin by adding up all the refinancing costs. You may want to include the time you would spend in locating necessary documents, calling a few lenders, and completing the application process.

Next, call a few lenders to determine current interest rates and your monthly savings in interest with a new loan. Since you are probably deducting your mortgage interest on your income tax, figure your monthly after-tax interest savings by multiplying your new mortgage interest monthly payment by your income tax bracket.

For example, if you are in the 24 percent tax bracket, multiply your monthly interest savings by 24 percent to figure the lost tax savings. Then, divide the total refinance costs by your after-tax monthly savings to learn the number of months it will take you to break even with your current mortgage.

Utah has the highest refinance approval rates. (Graphic: David Foster/Cashay)
Utah has the highest refinance approval rates. (Graphic: David Foster/Cashay)

Summary of refinancing mortgages

The decision to refinance your existing mortgage should not be made lightly. You need to weigh the pros and cons of refinancing. You need to evaluate whether it makes sense in light of your financial goals and objectives.

Some of the reasons for refinancing an existing mortgage include interest rate reduction, reducing or extending the mortgage term, and debt consolidation. On the down side, there is potential decrease in equity and the need to keep your home long enough for your monthly interest savings to cover refinancing costs.

Whatever your reason for considering refinancing, weigh the advantages and disadvantages carefully. This is a very serious and potentially costly decision to make.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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