Explanation of Mortgage Refinancing
With the refinancing of a mortgage, homeowners seek to replace their current loans with more financially attractive products. As interest rates fall, refinance loans tend to become more popular with consumers keen to reduce their monthly payments, tap into the equity they've built up in their homes or simply to increase or decrease the loan term. Whatever the reason, the financial implications are significant, and it's not a decision to be taken lightly.
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Why Refinance?
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The main reason for refinancing a mortgage is to save money. This usually takes the form of a new mortgage with a lower interest rate. Interest rates continually fluctuate according to changing market conditions and a lower interest rate generally means lower monthly payments. Interest rates are even lower if the mortgage is for a shorter term. For example, the interest rate on a 15-year mortgage will be lower than that of a 30-year mortgage, although since the loan term is shorter, the monthly payment will be higher. The upside is that the interest paid over the life of the loan will be significantly less and the homeowner builds equity in the home more quickly.
Another reason to refinance is the desire to change from an adjustable rate mortgage (ARM) to a fixed rate mortgage. ARMs are loans whose rates are tied to the market, which means that the monthly payment fluctuates as interest rates change. For many, changing from the unpredictability of an ARM to a fixed rate loan with a consistent payment brings considerable peace of mind even if the interest rate is not exceptionally low.
Cash-out Refinancing
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When you refinance a mortgage, you effectively pay off the old mortgage balance and create a new mortgage. Depending on the amount of equity in the home, you may be able to refinance an amount over and above the value of the existing liens on the home, and take out the difference as a cash payment. This is referred to as a cash-out refinance. Typically used by homeowners to make home improvements, pay off credit cards or even to make large purchases like a boat or car. The advantage of such a mortgage is that you're able to put the equity you have in your home to good use. The drawback is that you're reducing the equity that you've built up in your home and are extending the life of your mortgage, which means you'll be paying more to the bank in interest in the long term.
Eligibility
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Qualifying for a refinance of your mortgage is similar to the process you go through with the original mortgage loan. You have to show proof of income, disclose your assets and liabilities, and show your credit-worthiness. If your credit score is stellar, you'll qualify for the best available interest rate; if not, then you'll have to settle for a higher rate. On top of this, there'll be an appraisal on your property to determine its value. From this, the mortgage company will determine whether the loan-to-value (LTV) ratio is favorable to them. Generally speaking, lenders like to see that the loan amount is less than 80 percent of the appraised value of the home before approving it. If it's more than 80 percent of the appraised value, they may still approve the loan but also require you to purchase private mortgage insurance (PMI).
When Not to Refinance
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If you've held the current mortgage for a long time, refinancing may not be such a good idea. The way mortgage loans are amortized means that in the early years of the loan, most of the monthly payment goes toward paying off interest owed, with very little paying down the principal. Each year, the amount of the payment that pays down the principal gradually increases, so that in the later years of the mortgage, most of the payment is applied to the principal. If you refinance in these later years, the amortization process starts anew and you revert to paying back interest rather than building equity in the home.
Another reason not to refinance is if you're planning to sell the property in two or three years. Even if you save money on the new monthly payment, it may take years to break even on the deal when you take into consideration the costs of refinancing, which will likely be rolled into the new loan amount.
Costs
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Refinancing costs can vary greatly from lender to lender, but they generally fall somewhere between 2 to 4 percent of the loan amount. Included in this amount is a document preparation fee, an application fee, lender closing fee, title examination and title insurance. You may also elect to pay points, which are optional fees that effectively buy down the interest rate on the loan. A point is equal to 1 percent of the loan amount and may be worth paying if you intend staying in the home for a long time in order to fully benefit from the long-term interest savings.
Finding the Best Deal
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When refinancing, it pays to let different lenders know that you're shopping around for the best terms so that they have to compete for your business. A good place to start is with your current lender, who may be anxious to retain you as a customer. It's also worth asking the lender if they'll negotiate some of the fees involved in the loan. Either way, it's wise to get good-faith estimates of the loan and the expected closing costs from two or three different lenders so that you can compare them and find the best deal.
Tax Implications
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Although much of your monthly payment in the early years of a refinanced mortgage go towards paying off interest, with very little going towards the loan balance, this does at least have tax benefits come tax time. All of this interest, which will be reported to you by the lender on a 1099 form, is fully tax deductible. There are those who advocate cash-out refinances as part of a debt-consolidation plan where credit cards are paid off. The rationale is that the tax savings are even greater, since unlike mortgage interest, interest payments on credit cards are not tax deductible. However, many financial advisers question the wisdom of turning unsecured credit card debt into a 15 or even 30 year debt secured by your home, especially since there's always the risk of continuing credit card use. It can be a complex issue, and to fully understand the tax consequences of any big financial decision, it's always advisable to consult a tax professional.
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