Refinancing Your Mortgage
Could your home be the answer to your financial problems?
Many people refinance their home mortgage, which means paying off the initial loan through taking out another, in order to maximize savings or gain financial flexibility. Indeed, the most common reasons cited for a mortgage refinance are as follows:
- To reduce monthly payments through a lower interest rate
- To reduce the term of their loan
- To change from an adjustable rate to fixed rate mortgage (or vice versa)
- To access cash from the equity in their home
- To consolidate debt
However, refinancing a mortgage is no small act. Just like the process used to gain the initial loan, refinancing involves everything from home inspections to close scrutiny of your finances. It also comes attached to fees including legal counsel (depending on your state) and closing costs. Not to mention the time, effort, and stress involved in the whole process.
Therefore, whether it is out of prudence or desperation, it is incredibly important to carefully consider the ramifications of a refinancing your home mortgage before the process begins. Some people can and do save a lot of month through this process, but in other cases the “savings” not always what they seem. In addition, the short-term benefits of your refinance do not always outweigh the long term real costs.\
Two Types of Refinance Loans
Before we go over the real value of home loan refinancing, it is important to draw a line between the two broad types of refinance loan that people can get. These two loans collectively cover the all common reasons for a home loan refinance and present borrowers with very different sets of benefits and drawbacks.
First, there is the rate-and-term refinance loan which, ideally, is designed to save the borrower money over time. When taking this loan, borrowers change either the interest rate or the length of their loan in order to make their payments more affordable and/or save money over the lifetime of their loan. This type of refinance includes borrowers transitioning from an adjustable rate mortgage (ARM) to a fixed rate mortgage or vice versa.
The other type of home loan refinance is known as a cash-out refinance loan. In this case, the new loan that borrowers take is for an amount greater than what they owe on the original loan (but less than the value of the home). They can then use the extra cash to pay off other debt or make a purchase, such as home improvements and renovations.
The Benefits and Drawbacks of Rate-and-Term Refinancing
On the surface, a rate-and-term refinance seems pretty simple and makes a lot of sense, particularly for people who purchased their home more than 6 years ago, when interest rates were much higher than they are today. And, when the detailed numbers work, a rate-and-term refinance can save you tens of thousands of dollars over the lifetime of your loan. But only when the detailed numbers work, so you need to pay attention.
For starters, there is a cost to a refinance and if you don’t stay in your home for more than a few years, you may not be able to recoup that cost. For example, if you pay $3500 in closing costs and other fees for a refinance that saves you $150 a month, it would take you 23 1/3 months to recoup the initial $3500. So, you don’t actually “save” anything unless you stay in your home for more than two years.
The term part of your rate-and-term also matters. Say, for example, you took out a $186,000, 30-year loan at 5% interest 10 years ago with a monthly payment of $998. Today, you would owe $146,000 in principal on that loan, which you would pay off over the next 20 years.
However, if you refinance into a new 30-loan, at a lower 4% interest rate, you can “save” by reducing your monthly payments to $697. Yet, because you will be paying it off over 30 years, rather than 20, your total payments for the loan actually increase. Over time, the new loan will cost you $250,920 compared to $239,520.
Of course, there is a middle ground. If you pay off the new 30-year loan in 20 years, your monthly payment becomes $885 and your total cost is $212,400. So, the devil (and the savings) is in the details!
The Benefits and Drawbacks of Cash-Out Refinancing
The cash-out refinancing loan is not quite so complex since the point of this type of refinance loan is not to save money, but to get it. Many people see the equity in their home as a cash cow, which allows them to pay off high-interest debt or make large purchases including paying for college or making home improvements at a low interest rate.
However, while it is hard to argue the benefit of the cash-in-hand that cash-out refinancing offers, particularly in the short term, this type of financial move often becomes a slippery slope. There are a lot of seemingly-reasonable justifications for cash-out refinancing including the lower interest rate that it offers. However, the 30-year term of a mortgage loan, compared to the 10-year term of most educational loans, for example, may cancel out the real savings.
Furthermore, using your home’s equity to consolidate debt can help you to gain control over your finances, but only if it accompanies a more thorough financial cleanse and permanent behavioral changes. Remember, your mortgage is a secured debt whereas credit card debt is unsecured. A non-payment on a credit card may lead to some nasty calls from debt collectors, but a non-payment on your mortgage can lead to foreclosure. In addition, many people clear out their credit cards only to run them up again once their credit appears, leading to a perpetual cycle of debt and consolidation that is really just a ticking time bomb waiting to go off.
So, Should You Refinance?
Refinancing your mortgage is no small act. It involves a lot of work which is just a waste of time if it doesn’t yield much by way of savings or help in getting your finances under permanent control. So, while a refinance can be a prudent financial move for some, it can just as easily be a disastrous one for others.
As a general rule of thumb, remember that refinancing costs between 3% and 6% of the loan’s principal and is only a good idea if you plan to stay in your home for at least a couple more years. After that, an in depth look at your personal finances, goals, and behaviors is the only way to determine if this type of radical financial move is the right one for you.