Have you ever had a conversation with a family member, friend, or neighbor about how much money they saved by refinancing? Did this conversation prompt you to consider whether you are losing out by not doing the same?
What is Refinancing?
Simply put, refinancing is obtaining a new mortgage to replace the original. Borrowers refinance for several reasons: lower interest rates, lower monthly payments, or cash out on home equity for large purchases.
Our Story
We had considered refinancing in the past, but it was never beneficial for us to do so. It would have cost us thousands of dollars in refinancing fees. Then our primary bank called and asked if we wanted to refinance. They gave us a limited-time offer: total refinance costs of $389 out of pocket (a steal!). Usually, these amounts can range from 1-3% of your loan balance. Also, they were offering an interest rate of 3.59% based on our credit score. At the time, our mortgage interest rate at another bank was 4.375%. Our decision then was whether to refinance or not. Here was an opportunity to get a lower interest rate. We also wanted to change our term from a 30-year mortgage to 15 years to reduce our overall mortgage expenses.
We performed the analysis. Based on the new interest rate, and the shorter loan term, the pay-back period of the additional refinance costs was just seven months. Typically, even with a lower interest rate, it can take up to five years to recover these costs, especially if there are penalty fees. Our monthly payments went up by $366 but with an overall saving of over $40,000! In our case, refinancing was a no-brainer.
There are several things to consider when deciding whether to replace your current mortgage with a new mortgage. A refinance option may be suited to one borrower but not necessarily best for the next person.
Evaluating the Reasons
Every borrower contemplating a refinance should consider their reasons and calculate the total costs and benefits. There is no one size fits all in this case.
1. Get a Lower Interest Rate
All things being equal, lower interest rates equal lower monthly payments and savings on interest paid. This is the most obvious reason for refinancing a home. Some borrowers can obtain lower interest rates due to an increase in their creditworthiness or a drop in mortgage rates. To determine if refinancing is beneficial, the borrower needs to evaluate the refinancing costs. These costs include all penalty fees, application fees, and attorney fees.
In many cases, the long-term savings gained from the lower interest rate will offset the costs, particularly when the borrower intends to stay in the home for the foreseeable future. However, if the borrower expects to sell soon, they may not be there long enough to recover the refinance costs. In such cases, the borrower should calculate a break-even point to determine the length of time they need to remain in the home to recover the costs.
2. Switch from ARM to Fixed-Rate Loan
An adjustable-rate mortgage (ARM) has rates that adjust (reset) at specific periods over the full loan term. Usually, the loan starts with a lower introductory rate, then increases after a predetermined period. Switching from an ARM to a fixed-rate can be an excellent move if you intend to stay in your home for a long time. After the introductory period of the ARM, you can obtain a fixed rate that will be lower than the increased rate of the ARM. Again, you must perform an analysis to determine if it is beneficial to switch, after considering the associated fees.
3. Consolidate Debt
Refinancing to consolidate debt can be a dangerous financial move. On the surface, it seems to make sense to pay off high-interest debt with a low-interest mortgage. However, there are potential problems with this move. It transfers unsecured debt (for example, credit card debt) into a mortgage that is backed by your home. This decision places the collateral (your home) at risk, unlike an unsecured personal loan. If you later lose the ability to make payments, you can lose your home. This loss is a more significant consequence than not paying your credit card debt. Also, some borrowers cannot resist building new balances on the paid-off credit card, defeating the original purpose of the refinance.
4. Change (Extend or Shorten) Mortgage Term
Some borrowers seek to lower their monthly payments by refinancing with a longer loan term. Let’s say you have a 30-year mortgage of $250,000. Ten years later, you now have a loan that is $200,000. Taking out a new 30-year loan would reduce your monthly payments. However, this increases your loan obligations by ten years, and total interest paid in the long-run.
Conversely, refinancing to shorten the loan term can reduce the overall interest and total costs you pay. However, your monthly payment would increase. Shortening the loan term can be a sound financial move if you wish to pay off the loan quickly and can afford larger payments. An alternative to refinancing for a shorter time is to make larger payments directly to the principal. Your monthly mortgage obligation remains the same, and you avoid the refinancing fees while saving on interest expenses. Calculate the benefits and costs of each option to determine which decision is beneficial.
5. Obtain Cash for Investing/Large Purchases/Other
Generally, homes increase in value in the long-term, which translates to an increase in equity. This increase creates a cash resource when refinancing. Many borrowers view this as an opportunity to put cash to good use: make a purchase or to invest. The problem with extra money is that it is easy to spend. Borrowers must evaluate the consequences of increasing loan obligations against the value gained by the purchase or investment opportunity. For instance, paying off a mortgage at 5% interest per year may be a better deal than putting cash into a certificate of deposit that generates only 2.5% interest.
The Bottom Line
As a homeowner, refinancing can be a wise financial move for you. However, you must ensure you understand the reasons for refinancing and evaluate your options before deciding.
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Aliethea Dickson, MBA, is the Co-Founder & CEO of Top Deal Properties LLC and AD Home Rentals LLC. Aliethea and her husband, Thomas, are residents of Central Ohio and pride themselves in uplifting the local community one property at a time. They are professionals with a combined 25+ years of corporate business experience in the fields of accounting, auditing, and financial analysis.