How to Refinance a Home Loan
Be sure it makes sense for your situation
When interest rates fall, homeowners rush to refinance mortgages, often without pausing to consider whether it makes financial sense. It often does, but interest rates are only one portion of a bigger picture. Serial refinancers who take out new mortgage loans every time rates drop a quarter-point ultimately end up adding principal and extending the term of the loan.
Refinancing is basically the process of taking out a new loan to pay off an original loan or, in the case of a serial refinancer, a loan that already has been refinanced. It also is possible to refinance a home equity loan.
There is more than one type of mortgage, and it is possible to refinance with a different type of mortgage than the original loan. For example, having a fixed-rate mortgage doesn't mean that you can't take out an adjustable-rate mortgage when you refinance. However, before you consider switching, make sure you completely understand the terms of the new loan. Other mortgage loan types you may want to consider include interest-only, option-ARM, FHA, and reverse mortgages.
Refinancing a mortgage is not as simple as changing to a lower interest rate or otherwise different terms. It involves taking out an entirely new loan, and that means fees. If a mortgage lender is not making money by charging upfront costs, its fees are either rolled into the loan or paid through a higher-than-market interest rate.
Since Jan. 1, 2010, lenders have been required to guarantee their good-faith estimates (GFEs). If certain rates change at closing, they are required to pay them.
Fees might be applied for items such loan discount points, loan origination, processing, administration, application, inspection, document preparation, appraisal, credit report, title policy, escrow, reconveyance, beneficiary demand, notary, loan tie-in, delivery and courier, email doc, tax service, or recording Many of these are "garbage fees," which means they can be negotiated by the borrower. If you ask, the lender might waive them.
You also might be charged a yield-spread premium (YSP), which is money a bank gives back to a mortgage broker for bringing your loan. Bear in mind that if the lender did not pay a YSP to the broker, you might have received a lower interest rate on your loan or paid fewer points. By the time you discover this, you are probably closing the loan. So, ask upfront.
The red tape of applying for a new loan can be a hassle, and the fees can be expensive, but refinancing a mortgage still can be a good option. Some of the most common benefits include:
- Lower monthly payments: If you plan to stay in a home long enough to break even on the refinance costs, a lower interest rate and lower payment leads to greater monthly cash flow.
- Shortening the amortization period: If your interest is substantially lower than your previous rate, you might want to consider shortening the term of your loan in exchange for a slightly higher mortgage payment. Before you do this, figure out if you could invest that extra principal portion elsewhere for a better rate of return.
- Cash in hand: Many homeowners refinance to obtain cash to invest at a higher rate of return than the new interest rate.
The potential for savings is great, but it's not always reality when it comes to refinancing. Before assuming that refinancing at a lower interest rate is automatically a good idea, do your own math to be sure. Some reasons to skip refinancing include:
- Costs: It costs money to get the loan, which you might not recoup through a lower interest rate for a number of years. To figure this out, add up all the fees. Figure out the difference between your old mortgage payment and your new payment. Divide that difference into the loan fees, which will equal the number of months you must pay on your new loan to break even. If your loan fees are $4,000, for example, and the monthly savings will be $100 per month, it will take you 40 months to break even on the refinance.
- Longer amortization period: Although you have the option of shortening your amortization period, you might not qualify for the higher payment nor may you want to pay more each month just to pay off the loan faster. Borrowers generally extend the term of the loan. If you refinance a loan with 25 years remaining for a new 30-year loan, you have turned what originally was a 30-year loan into a 35-year loan.
- Bigger mortgage: By rolling the costs of your refinance into the loan itself, you are taking out a bigger mortgage, which eats away at your equity position. Moreover, if you take out cash, called a cash-out refinance, your loan balance will be increased.