Refinancing. You've heard about it on the news, you've considered it yourself, but there's only one problem - you're not sure what it is.
Don't be embarrassed. In simple terms, refinancing means paying off your existing mortgage with a new one, possibly to take advantage of lower interest rates, lower your monthly payment, or consolidate a first and second mortgage into one loan. Sound like a good idea? Then keep reading.
If you make an informed decision, your refinance could end up saving you some serious money over the life of your loan. But jumping in without doing your research could cost you, so it pays to make sure you're refinancing for the right reasons.
Wondering what those "right reasons" might be?
There are several good ones, but the first and foremost is to save money over the long run, says David Kutner, senior loan advisor at Mortgage Technology in California, a mortgage company specializing in residential loans.
There are all kinds of potential scenarios where refinancing could save you money - but it's not going to be the right move for everyone; depending on your situation, refinancing might cost you more money than it will save you.
Not sure if a refinance is a good choice for you? Read on to find out about some of the "right reasons" to refinance your mortgage.
Reason #1: You Want to Pay Off Debt Faster
Do you fantasize about paying off your mortgage? Refinancing could help you pay it off faster - and save you money in the long run, too.
"There are two ways refinancing could help you pay off your debt faster," says Kutner. "The first way is to take a shorter term loan." How? Refinance your 30-year loan to a 20- or 15-year loan. "Your payment might be higher, but you would pay off your mortgage faster with a total cost - after you've paid the loan off - that is much less than you'd have paid if you'd stayed with your original loan."
Kutner also suggests a second way you could pay off your debt faster by refinancing: "Refinance at a lower interest rate, but continue making your prior payment."
Consider this example: let's say you were paying $1500 a month for your old mortgage, then you refinance to a lower interest rate loan with a new payment of $1200 a month (saving you $300 a month). If you continued to make your $1500 a month payment, that extra $300 would go directly to the principal of your loan.
In essence, you could pay off your loan faster, and as a result pay less in interest over the life of the loan.
But don't make the mistake of thinking that simply refinancing will automatically mean you'll be paying your loan off faster.
Scott Groves, a mortgage loan officer in Southern California, offers one caution to think about when refinancing: "Ironically, a lot of times when people refinance, they extend the term of their mortgage."
Take this instructive example: You've got 27 years left on your original 30-year mortgage when you refinance from a $1500 to a $1200 monthly payment. If you simply make that $1200 monthly payment - without including the extra $300 toward the principal every month - it will now take you 30 years to pay off your loan. That's three years longer than it would have if you'd just stuck with the old loan.
So if your ultimate goal for refinancing is to pay off your mortgage, not keep it hanging over your head, remember to consider the loan term.
Reason #2: You Could Reduce Monthly Payments
Both Kutner and Groves agree that lowering the monthly mortgage bill is typically the number one reason people look into refinancing. Sounds nice, doesn't it?
"For most people, refinancing is all about improving that monthly payment scenario," Groves says. "If your current interest rate is five percent and you drop to four percent, depending on the loan, that one percent change in your interest rate might save you $100 to $300 a month."
A lower monthly payment, however, should not be the only factor you consider when deciding to refinance. In fact, Kutner explains that not every homeowner will benefit from a lower monthly payment.
"Even if the interest rate of the new loan is lower than your current interest rate, the cost of the refinance might be so high as to make the overall cost not worth it," he cautions.
To illustrate this point, Groves runs a few numbers for us. "If you are looking at dropping your rate to save $200 a month, but it costs you $5,000 to do the refinance, is it worth it?" he asks. That all depends on how long you're planning to stay in the property.
For example, if you're saving $200 a month, it will take 25 months to recoup the $5,000 you spent for the refinance. If you're planning on staying in the house for the next two decades, great. If you're planning on moving next year, maybe you shouldn't refinance.
Reason #3: Your FICO Credit Score Has Improved
You may be asking yourself: If I already own my home, why does my FICO credit score matter? Well, it affects the new loan you're hoping to get in more ways than you might know.
Before we explain why, let's review the enigma that is a credit score. Credit reporting companies look at your history of paying bills, your available credit, and other factors in order to determine your credit score.
Financial institutions then make decisions about loaning you money based on that score. FICO (or Fair, Isaac and Company - a public company that provides analytics to help financial services companies make decisions) takes your information from the credit reporting companies and generates your FICO score. Scores range from 300-850, according to myFICO.com.
And like most things, the higher you score the better your "creditworthiness," which means banks or mortgage companies will be more likely to loan you money. But if your score is below 620, you might not be able to get a loan from a lender, Kutner says.
It also pays to have a higher score because you could be eligible for a better interest rate and the cost of the loan might be less.
"Typically banks will offer better rates to people with higher credit scores," says Kutner, "and lenders might lower the cost of the loan for people with higher credit scores." In fact, Kutner has counseled some people to improve their credit scores and then come back to do a refinance once their scores have improved.
The time needed to improve a score varies from person to person. "Some people take a year to do it, some can do it all at once," Kutner says.
Curious about improving your credit rating? Start by checking out your credit report for free at www.annualcreditreport.com (the official site for consumers to get their free credit report). Carefully examine your credit history and try to correct any errors you see.
You can also help raise your credit score by always paying bills on time, and by paying down as much of your credit card debts as you can.
Reason #4: Your Work Situation Has Changed
Yes, there are trust-fund kids out there. But let's face it, most of us get our money by working for it. And when your job situation changes, your income situation often follows suit.
It's probably pretty obvious that if you've been out of work and then you land a job - or if you've recently been promoted - your higher steady income could go a long way toward helping you qualify for a new loan, Kutner says. That's because a steady, dependable stream of income helps ensure lenders that you'll be able to pay your mortgage every month.
But there are other, trickier job situations where a change in employment may help you qualify for a refinance.
"Let's say a person was self-employed and now they have a salaried job with a steady income," Kutner says. "That might make them more qualified for a new loan," even if they're making the same amount as when they were self-employed.
Why? Kutner notes that it's harder for a self-employed person to get a loan than it was five or six years ago. This is partly due to changes in lending practices, which previously allowed borrowers to simply state their income. As long as it seemed consistent with their type of job, lenders would accept it. But today lenders require a much stricter accounting for self-employed people.
Does that mean you should consider refinancing every time you get a new job or a promotion at work? Not exactly.
"If you can get a better rate with more income, that's a possibility," Groves says. "But you shouldn't reevaluate your mortgage every time you have a life change."
Reason #5: You Could Pay Less Interest
We've already talked about one reason to shorten your loan term, but another benefit of paying off a loan faster is reducing the interest you'll pay over the life of your loan.
"A lot of people are finding they can refinance from a 30-year mortgage to a 15-year mortgage and their payment will be $100 or $200 more a month, but it eliminates 15 years of interest payments," Groves says. "That could save them several hundreds of thousands of dollars over the life of the loan."
Groves shares an example from a recent refinance he did: "A client had 28 years left on a 30-year loan and refinanced to a 15-year loan. It increased their payment $200 a month, but over the life of the loan it will save them $140,000 in interest."
That's not an insignificant savings.
Kutner offers another way to see this. If you hold onto a 30-year loan with a higher interest rate and never put anything additional down on your principal, you could end up paying as much in interest as you pay for your entire house. Your home could end up costing you twice what you agreed to pay when you bought it.
Essentially, the amount you will have spent in interest could have bought you a second house. If that sounds crazy to you (and it should), you might want to consider refinancing to a lower interest rate, or a shorter term.
Reason #6: Your Marital Status Has Changed
Life can throw some surprises your way. You might meet and fall in love with your soul mate... or, sadly, your marriage of a decade could come to an end. Either way, your changing marital status might lead you to refinance.
Kutner says he has dealt with these types of situations. "I get called when people have gone through a divorce," he says.
Even if it's an amicable divorce, if the one party is keeping the house, the other party is still listed on the loan. The loan ties them together financially, and the only way to change it is to sell or refinance the house. A divorcing couple might want to refinance (even if they end up with the same rate) just to separate their financial obligations.
The same could be said for anyone - siblings, friends, business partners - who bought property together and now need to separate. A refinance is one way to avoid selling the property and still allow one party out of the responsibility of paying for a mortgage they're no longer interested in or able to pay.
Kutner offers another reason why refinancing after a separation might be a good idea. "The mortgage also shows up on your credit report," he warns. "So you'd be liable if your ex doesn't pay."
This might be one situation where - even if it doesn't feel like you're benefiting financially - refinancing might bring you peace of mind. It might also protect you financially and legally from the actions of someone you're no longer related to. That's something to seriously consider.