Welcome to our week-long series on refinancing your mortgage. In this first of five articles, we look at when you should refinance.
As I mentioned yesterday, my wife and I just closed on the refinancing our mortgage. We purchased our current home in 2004 and obtained a 30-year fixed rate mortgage at 5.625%. We are refinancing the loan to another 30-year fixed rate mortgage at 3.875% (today’s mortgage rates are incredible). And I thought I’d use this opportunity to cover a number of topics when it comes to mortgages, starting with one we hear a lot–“When should I refinance my mortgage?”
While there are a lot of difficult decisions to make when it comes to money, refinancing your mortgage doesn’t have to be one of them. In fact, deciding whether you should refinance your home loan is generally a very simple analysis. Let’s look at the five primary reasons to refinance a mortgage, and then some specific circumstance that can make the decision more difficult.
Refinancing to lower your interest rate
Lowering the interest rate on a mortgage is the primary reason most homeowners refinance their home loan. Back in the day, the rule of thumb was to refi a mortgage when the rate had gone down by at least 1%. Today, a rule of thumb is not enough to make a decision. Instead, divide the cost of refinancing by the monthly interest you’ll save with the lower rate (adjusted for lost tax deductions). The result will tell you how many months it will take you to break even.
In our case, the new home loan will cost us about $5,000 and save us $600 a month in interest. Because our home mortgage interest deduction will be lower, we lowered the $600 savings down to $400 to evaluate the refinancing. Dividing $5,000 by $400 means it will take us about 12 months to break even. Because we have no plans to move in the foreseeable future, refinancing our mortgage was an easy choice.
Refinancing after your credit score improves
In same cases, a refi may be justified if you credit score has improved since you purchased the home. You may be able to purchase a home with a credit score as low as 620, but the interest rate you get won’t be the lowest available. If you’ve improved your credit score significantly, you may qualify for a better rate that makes refinancing your mortgage a smart move.
Refinancing an ARM into a fixed rate loan
Even if rates haven’t gone down, moving from an adjustable rate mortgage (ARM) to a fixed rate mortgage is often worth the cost of refinancing. In fact, in some cases homeowners will pay a slightly higher interest rate with the fixed rate loan. In exchange, however, you get the peace of mind that your rate won’t go up during the life of the loan. With an ARM, rates can go up significantly, depending on the terms of the loan and prevailing interest rates. And given the historically low rates we see today, chances are that the rates on ARMs will increase significantly over the coming years.
Refinancing from an ARM to a fixed rate loan is the approach I’ve taken on investment properties I own along with a business partner. When we purchase the homes, we almost always get 5-year ARMs from a portfolio lender (one who doesn’t sell the mortgage). We get the ARMs because the lender allows us to finance 100% of the improved value of the property. But we always refinance to a 30-year fixed rate mortgage before the five years expires.
Refinancing to lower monthly payments
In some cases lowering your monthly payments is the goal of a refi. For example, even with the same rate, refinancing a 30-year mortgage that has 22 years remaining back out to another 30-year mortgage will lower your monthly mortgage payments. There is a big downside to this approach. First, you extend the time it takes to pay off the mortgage. And second, you substantially increase the amount of interest you’ll pay. In some situations, however, lowering the monthly payment is a necessity.
Refinancing to get cash out
Finally, some refinance their mortgage in order to pull additional cash out. Called a cash-out refinance, this approach has several shortcomings. First, in today’s mortgage market, it can be extremely difficult to qualify for a cash-out refi, particularly given the low real estate values. Second, the interest rates on a cash-out refi will be higher than if you took no cash out. As a result, it can be an expense way to get at cash. Note that you can typically include closing costs in the refinance amount without being deemed to have taken cash out.
So why do most people refinance a mortgage? Freddie Mac answers this question to some degree in two quarterly refinance activity reports. Here is some data from these reports covering the fourth quarter of 2010:
- 95 percent of refinance loans were fixed rate
- 32 percent of borrowers who paid off a 30-year fixed-rate loan chose a 15- or 20-year loan
- 70 percent of borrowers who refinanced a 20-year loan chose a 15-year loan
- 46 percent of homeowners who refinanced their first-lien home mortgage lowered their principal balance by paying-in additional money at closing
- 16 percent of homeowners increased their loan balance (cash out) by at least 5 percent
- The median interest rate reduction was about 1.25 percentage points, or a savings of 22 percent in interest costs
For a breakdown of the type of mortgage homeowners obtained as part of their refinance, see the tables below. The first table shows refinancing data for the fourth quarter of 2009, while the second table shows data for the fourth quarter of 2010:
Tomorrow we’ll look at Home Affordable Refinance Program (HARP), which can help millions of people refinance their mortgage.
Photo credit: nikcname