Would you like to lower your monthly mortgage payment, or maybe reduce the total amount of interest that you will pay on your home?
With interest rates at an all-time low, it may seem like a no-brainer to refinance.
But before you jump on the "refi" bandwagon to secure a new loan for your home, experts suggest taking a cautious look at the pros and cons, and how they apply to your particular situation.
"We're seeing a lot of people refinancing for a lower interest rate or a shorter term," says Frank Donnelly, president of the Mortgage Bankers Association of Metropolitan Washington, D.C. "But there are some situations when refinancing might not be worth it."
So, before you make this big decision, you'll want to first consider these perks and pitfalls of refinancing.
Perk #1: You Can Score a Lower Interest Rate
What's the biggest benefit of refinancing today? A lower interest rate.
In fact, for the week of January 17th, rates were at an average of 3.38 percent for a 30-year mortgage, according to Freddie Mac.
And with rates this low, it's no wonder that some 3.3 million people refinanced their mortgage in 2012, according to data by Informa Research Services, a leading financial information provider to the financial industry.
"At one time, the general rule of thumb was that it paid to refinance only when the current rate is two percentage points lower than what you are currently paying," but that's not the case anymore, according to the National Association of Realtors' (NAR) online Refinancing Guide.
So, even if your current rate is 4.5 percent, "it might make sense to refinance," according to Rhonda Porter, a mortgage originator in Kent, Wash. You'll just have to take into consideration how much it costs to refinance, and how long it will take to recoup the costs. If the savings will outweigh the costs, scoring a lower interest rate is great reason to refinance.
Perk #2: You Can Adjust the Length of Your Mortgage
Depending on your financial situation, refinancing to adjust the length of your mortgage and in effect, your monthly payments, could offer significant benefits.
How significant? Well, interest rates for shorter-term mortgages are lower than those for a 30-year mortgage, Donnelly says. And just like paying off credit card debt in one year versus five years, shortening the loan term means you will pay less total interest on the mortgage.
Just consider this example from the Federal Reserve's mortgage refinancing guide:
|Monthly payment||Total interest|
|30-year loan @ 6.0 percent||$1,199||$231,640|
|15-year loan @ 5.5 percent||$1,634||$ 94,120|
So, if you recently got a significant raise or received a huge inheritance, you might be interested in shortening your loan term and making bigger monthly mortgage payments.
On the other end of the spectrum, if you're having trouble making payments and are looking for a way to reduce your monthly payments, refinancing could help with that, too. You could go from a 15-year mortgage, for example, to a 30-year term and thereby lower the amount that needs to be paid per month, Donnelly notes.
Perk #3: You Can Lock in a Fixed-Rate Loan
Did you sign up for an adjustable-rate mortgage (ARM) in order to get the lower initial rate that ARMs offer, but are now seeking the security of a fixed-rate mortgage?
If so, now is a great time to let go of the uncertainty of an ARM (which offers a fixed rate for a short period of time, such as one, three, or five years, and then adjusts yearly) in favor of a loan with a fixed rate that will never change, Donnelly says.
"Right now, there's not a very big difference in rates between fixed- and adjustable-rate loans," Donnelly says.
With that mind, it doesn't make much sense to stick with a risky ARM, especially considering this: "Rates and payments can rise significantly over the life of the loan. A 6 percent ARM can end up at 11 percent in just three years if rates rise sharply," according to the National Association of Realtors.
Pitfall #1: You'll Have to Pay Closing Costs (and Prepayment Penalties)
Think of closing costs as the amount it costs to refinance your home.
According to the Federal Reserve, closing costs can add up to 3 to 6 percent of the outstanding principal of your loan, and include application fees, loan origination fees, and appraisal fees, among other things.
What's more, you'll also need to watch out for prepayment penalties, in which "some lenders charge a fee if you pay off your existing mortgage early," says the Federal Reserve. And while Donnelly says these penalties are now "virtually non-existent" on most new loans, if your lender does happen to charge you, it could equal one to six months of interest payments, according to the Federal Reserve.
Needless to say, closing costs and prepayment penalties can really add up. Of course, if you calculate that your savings from refinancing will outweigh these closing costs, then you're in the clear. Just make sure to do your due diligence and consider your options wisely.
Pitfall #2: You're Moving Soon
Is there a move to a new home in your near future? Then think carefully about those closing costs we just mentioned. If your goal in refinancing is to see a lower monthly mortgage payment, it takes time for those savings to add up to recoup your closing costs, Donnelly says.
And if you move in a few months, or even a year after refinancing, the costs of refinancing may be greater than your total savings, he says.
While every situation is different, "One rule of thumb is that if you're not going to recapture the closing costs within two years, it's not worth it to refinance," Donnelly says.
But, if you picture yourself growing old in your home, refinancing could provide significant savings.
Pitfall #3: Qualifying for a Loan is Not Easy
Because of the foreclosure crisis, "lenders are very particular now," about who they'll give a loan to, Donnelly says. This could make for a tougher refinancing process than you imagined.
In fact, there's a laundry list of documentation required in order to secure a new loan for your home. This includes your income and assets, credit score, and other debts, notes the Federal Reserve.
And if your credit score is lower now than when you initially took out your mortgage, you may have to pay a higher interest rate, which may defeat the whole purpose of refinancing.
Lenders will also compare the amount of your loan request to the value of your home and "If the loan-to-value (LTV) ratio does not fall within their lending guidelines, they may not be willing to make a loan, or may offer you a loan with less-favorable terms than you already have," says the Federal Reserve.
So, before you decide to take the plunge and refinance, it's important to figure out if you'll truly be able to reap the benefits of refinancing.
- Frank Donnelly
- interest rates