3 Things to Know About Mortgage Refinancing
Mortgage refinancing is all the rage when interest rates drop. Rates don't have to drop very far, either, before scores of homeowners decide that refinancing their mortgages makes sense. But it doesn't always make financial sense to refinance. Sometimes, mortgage refinancing is the worst thing you can do.
What is Mortgage Refinancing?
Refinancing a mortgage means the owners are paying off their existing mortgage and replacing that mortgage with a new loan. Generally, the costs associated with mortgage refinancing are rolled into the loan, meaning they are added to the existing balance, increasing the loan amount.
When a loan amount is increased, an owner's equity is decreased.
It is possible to increase the principal balance of a mortgage and lower the existing mortgage payment. That's why many borrowers gravitate toward mortgage refinancing. To lower the existing mortgage payment, the term of the loan is extended. But a lower payment might not pay off in the long run. It's often a short-term resolution.
Why It Extends the Term of Your Mortgage
When the term of the loan is extended, it will take longer to pay that mortgage in full. If you took out a loan when you bought your home, it was probably a 30-year loan. Say you decide to refinance your mortgage at the end of 5 years. Instead of looking forward to paying off your loan in 25 years at this point, you will now be paying on that mortgage for a total period of 35 years.
If your original loan was amortized for 30 years on a $100,000 mortgage at 6% interest, your monthly payment is $599.55. If you refinance that mortgage at $103,000, at 5.5%, your new payment is $584.82. Your loan will reset to a 30-year term. Most borrowers select a 30-year amortization period.
You will make an extra 60 months of payments and pay $35,065 more over the life of the loan, should you live in the property long enough to pay off your loan. If you decide to sell after mortgage refinancing, you will lose $3,000 of equity, plus whatever principal balance you had paid down on the original $100,000 loan.
Costs Associated With Refinancing
You will either pay for the costs of mortgage refinancing through a higher interest rate, or those fees will be added to your unpaid mortgage balance because few homeowners pay those costs in cash. There is no free ride. Following are typical fees paid to obtain a refinance:
Reduced Payments Are the Refinance Goal
It's hardly worth it to refinance your mortgage to save $15 a month under these circumstances. Most mortgage experts say you should be able to recoup your costs from mortgage refinancing over a 3-year period. If you've saved only $15 a month and it cost you $3,000 in fees, it would take 200 months to break even.
However, if your total costs to refinance your mortgage cost you $3,000, for example, and you saved $50 a month in your mortgage payment by lowering it by that amount, you would break even at the end of 5 years. Sometimes, people turn into serial refinancers, and every time interest rates drop a half a point or a point, they rush to refinance, thinking they are doing the smart thing when often it is the opposite.
Further, your situation could be unique, and refinancing might make sense to you when it would not to others at first blush. For example, say you owned a second home with a mortgage balance of $200,000. That mortgage might be paid at a slightly higher rate than today's rates. If your primary home's mortgage was, say, amortized over 15 years, you could probably refinance your primary home over 30 years, keep the payment the same, and pay off the mortgage on your second home.
If you are in doubt, ask a real estate professional who doesn't have a dog in the race, like an appraiser, or an escrow officer, or even a real estate agent to compute the math for you. Because if you ask a mortgage lender if you should refinance, most often the answer to that question is yes.
At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.