A mortgage is the biggest kind of debt most people will ever face. It is also long-term debt, since the average home loan lasts for 15, 20 or 30 years.
That's why on an investment as big as a house, smart homeowners are constantly looking for ways to minimize their debt and maximize equity, which is where refinancing comes in.
Refinancing simply means getting a new mortgage to replace your old one with the goal to reduce monthly payments, lower your interest rate, or to take cash out of your home for other purchases (e.g., remodels, college, cars, and vacations).
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According to the Mortgage Bankers Association, the average American refinances his or her mortgage every four years – and with good reason, since refinancing can result in some pretty sweet savings.
Main reasons to refinance:
Get a lower interest rate – This is the most popular reason to refinance. It simply means you are swapping a higher interest rate for a lower one, which can save you considerably on your monthly mortgage payments. Example: You have a $250,000 mortgage with a 30-year fixed rate of 6 percent. Your monthly mortgage payment is approximately $1,500. If after four years of owning your home you refinanced to a mortgage with an interest rate of 4 percent, your monthly mortgage payment would be $1,300 – a savings of $200 per month.
Switch your mortgage type – Suppose you have an adjustable rate mortgage (ARM) that offered great low introductory rates, but the rate is about to increase. By changing to a fixed-rate mortgage, you will have the comfort of locking into a rate that won't change, as well as getting a consistent monthly payment. Conversely, if you have a fixed-rate mortgage, but want the attractive low rates an ARM offers, you could switch to an ARM.
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Build home equity faster – Perhaps your financial standing has changed and you can pay more toward your monthly mortgage payments. Example: Depending on how long you have had your loan, by refinancing from a 30-year fixed to a 15-year fixed, you could greatly reduce your long-term interest charges and pay off your home more quickly. Or, if you didn't want to refinance, you can pay against your principal by making additional payments each month.
Take cash out – Called cash-out refinancing, you basically pull equity out of your home in the form of cash, but you add to your principal in the process. Example: Your home is worth $500k, you owe $300k on your mortgage and you have $200k in equity. By refinancing your existing loan, you take $100k out of your home in cash and then get a new loan – hopefully with a lower interest rate. Your mortgage will look like this: $500k home value, $400k mortgage and $100k in equity.
Is refinancing right for you?
Before you contact a lender, make sure it makes sense for you. Ask yourself these questions:
How long will I be in my home? The general rule is that unless you are planning to stay in your home at least another five years, then refinancing may not make sense. This is because a refi usually carries closing costs and the costs could outweigh the benefits. You usually "break even" at the five-year mark, which means you have paid for the costs to refinance.
Is there a prepayment penalty on my current mortgage? Since many mortgages carry a penalty if you pay off your existing mortgage, find out if you will be charged a "prepayment penalty." The amount varies, but it can add up to several months' worth of interest payments. Ask your lender.
What are the costs of the new mortgage? Lenders almost always charge fees for taking out a new loan. These can add up to an average of $5,000 to $10,000, depending on the size of the loan. Charges include application fees, appraisal, origination and insurance fees, plus title search, insurance and legal costs. Unless your new rate is at least a half a percentage point lower than your current rate, the fees may eat up your potential savings.
Will my tax savings be reduced? If you claim mortgage interest on your tax return, refinancing to a lower rate will mean that you'll have less mortgage interest to deduct. That means you might have to check with your tax advisor to see if your overall savings will be increased if you refinance.
Can I build equity faster? Opting for a shorter-term mortgage might make sense for someone who can now make greater monthly payments than when they originally financed. Example: A $350,000 mortgage over 30 years would mean payments of just under $1,700 at rates at 4 percent. A $350,000 mortgage over 20 years at a 3.25 percent interest rate would mean a monthly payment of just under $2,000 before taxes. The savings in interest between the 30- and 20-year notes is about $125,000.
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Can I improve the features of my ARM? These products have protective caps that limit how much your payments can increase in any given year over the term of the loan. It might be a good time to set new terms that you find more favorable.
Can I reduce my monthly payments? For those whose cash flow has changed, refinancing for a longer term will likely lower your monthly payments. This will increase interest owed, but it could provide relief given a new set of financial considerations.
Can I cash out some of my equity? Taking out a new mortgage with a larger principal could provide a cash infusion for a major project or other needs. The advantage is that you can get a lower interest rate than if you used a credit card or an unsecured loan for the cash. This makes sense if the current interest rate is lower than your existing rate.
Refinancing helps many homeowners stay in their homes for less money, or gives them the cash out they desire, but just make sure you do the math and understand how the new loan will affect you.