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When (And When Not) to Refinance Your Mortgage

Refinancing a mortgage means paying off an existing loan and replacing it with a new one. There are many reasons why homeowners refinance: the opportunity to obtain a lower interest rate; the chance to shorten the term of their mortgage; the desire to convert from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage, or vice versa; the opportunity to tap a home's equity in order to finance a large purchase; and the desire to consolidate debt. Some of these motivations have benefits and pitfalls. And because refinancing can cost 3% to 6% of the loan's principal and – like taking out the original mortgage –requires appraisal, title search and application fees, it's important for a homeowner to determine whether his or her reason for refinancing offers a true benefit.

 

Securing a Lower Interest Rate

 

One of the best reasons to refinance is to lower the interest rate on your existing loan. Historically, the rule of thumb was that it was worth the money to refinance if you could reduce your interest rate by at least 2%. Today, many lenders say 1% savings is enough of an incentive to refinance.

Reducing your interest rate not only helps you save money, it also increases the rate at which you build equity in your home, and it can decrease the size of your monthly payment. For example, a 30-year fixed-rate mortgage with an interest rate of 9% on a $100,000 home has a principal and interest payment of $804.62. That same loan at 6% reduces your payment to $599.55. 

 

 

Shortening the Loan's Term

 

When interest rates fall, homeowners often have the opportunity to refinance an existing loan for another loan that, without much change in the monthly payment, has a significantly shorter term. For that 30-year fixed-rate mortgage on a $100,000 home, refinancing from 9% to $5.5% cuts the term in half to 15 years, with only a slight change in the monthly payment from $804.62 to $817.08.

 

Converting Between Adjustable-Rate and Fixed-Rate Mortgages 

 

While ARMs often start out offering lower rates than fixed-rate mortgages, periodic adjustments often result in rate increases that are higher than the rate available through a fixed-rate mortgage. When this occurs, converting to a fixed-rate mortgage results in a lower interest rate and eliminates concern over future interest rate hikes.

 

Conversely, converting from a fixed-rate loan to an ARM can also be a sound financial strategy, particularly in a falling interest rate environment. If rates continue to fall, the periodic rate adjustments on an ARM result in decreasing rates and smaller monthly mortgage payments, eliminating the need to refinance every time rates drop.With mortgage interest rates rising, on the other hand, as they have begun to do, this would be an unwise strategy.

 

Converting to an ARM, which often has a lower monthly payment than a fixed-term mortgage, may be a good idea for homeowners who don't plan to stay in their home for more than a few years. If interest rates are falling, these homeowners can reduce their loan's interest rate and monthly payment, but they won't have to worry about interest rates rising in the future.

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Tapping Equity and Consolidating Debt

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While the previously mentioned reasons to refinance are all financially sound, mortgage refinancing can be a slippery slope to never-ending debt. It's important to keep this in mind when considering refinancing for the purpose of tapping into home equity or consolidating debt.

Homeowners often access the equity in their homes to cover major expenses, such as the costs of home remodelling or a child's college education. These homeowners may justify such refinancing by pointing out that remodelling adds value to the home or that the interest rate on the mortgage loan is less than the rate on money borrowed from another source. Another justification is that the interest on mortgages is tax deductible. While these arguments may be true, increasing the number of years that you owe on your mortgage is rarely a smart financial decision, nor is spending a dollar on interest to get a 30-cent tax deduction.

 

Many homeowners refinance to consolidate their debt. At face value, replacing high-interest debt with a low-interest mortgage is a good idea. Unfortunately, refinancing does not bring with it an automatic dose of financial prudence. Take this step only if you are convinced you'll be able to resist the temptation to spend once the refinancing gets you out from under debt. Be aware that a large percentage of people who once generated high-interest debt on credit cards, cars and other purchases will simply do it again after the mortgage refinancing gives them the available credit to do so. This creates an instant quadruple loss composed of wasted fees on the refinancing, lost equity in the house, additional years of increased interest payments on the new mortgage and the return of high-interest debt once the credit cards are maxed out again – the possible result is an endless perpetuation of the debt cycle and eventual bankruptcy.

 

The Bottom Line

 

Refinancing can be a great financial move if it reduces your mortgage payment, shortens the term of your loan or helps you build equity more quickly. When used carefully, it can also be a valuable tool in getting debt under control. Before you refinance, take a careful look at your financial situation and ask yourself: How long do I plan to continue living in the house? And how much money will I save by refinancing? 

 

Again, keep in mind that refinancing costs 3% to 6% of the loan's principal. It takes years to recoup that cost with the savings generated by a lower interest rate or a shorter term. So, if you are not planning to stay in the home for more than a few years, the cost of refinancing may negate any of the potential savings. It also pays to remember that a savvy homeowner is always looking for ways to reduce debt, build equity, save money and eliminate that mortgage payment. Taking cash out of your equity when you refinance doesn't help you achieve any of those goals.

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Different Mortgage Refinance Options

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Selecting A Refinance Loan

When you decide to refinance, you might be surprised that there are many types of refinances from which to choose.

Your refinance depends on factors such as

Following is a brief synopsis of each loan type and for whom each type is best.

Conventional refinance

A conventional loan is good for those who have decent credit and equity in their homes. Conventional financing does not require mortgage insurance with 20% equity. You can refinance into a conventional loan no matter what kind of loan you have currently. Learn more>>

FHA Streamline Refinance

Current FHA loan holders might consider an FHA streamline refinance. Going from FHA to FHA requires much less paperwork: no appraisal or income documentation is required. Learn more>>

HARP

These are high-LTV loans backed by Fannie Mae and Freddie Mac, and offered by local lenders. If your loan was opened prior to June 2009 and you have little or no equity, the HARP loan might be right for you. Learn more>>

VA Streamline

A VA streamline refinance replaces an existing VA loan with another VA loan with a lower rate. It's called a "streamline" loan because it requires no appraisal, and no verification of employment, income, or assets to qualify. Learn more>>

USDA Streamline

Current USDA mortgage holders can refinance with no appraisal. This program was recently rolled out in all 50 states. Learn more>>

Cash-Out Loans

You take equity out of your home in the form of cash by opening a larger loan than what you currently owe. The difference is forwarded to you at closing.

Conventional cash-out: Use conventional lending to tap into your home's equity. Learn more>>

Cash out a rental property: Grow your real estate portfolio using equity from your existing investment property. Learn more>>

Home equity line of credit: Should you get a cash-out loan or a home equity line of credit? It depends on whether you want to leave your first mortgage intact. Learn more>>

FHA cash-out: No matter which kind of loan you have currently, you are eligible to use an FHA cash-out mortgage up to 85% of your home's current value. Learn more>>

VA cash-out: Eligible military veterans can take a new loan up to 100% of their home's value. Proceeds can be taken as cash or to pay off debt. You can also refinance out of any loan using a VA cash-out loan. Learn more>>

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7 ways to get a better refinance rate

1. Increase your home's equity

By increasing your home equity, you create a lower loan-to-value ratio (LTV). This is the amount that you’re borrowing as a percentage of your home’s value. LTV is key to getting approved for a refinance -- and getting a lower interest rate -- because lenders consider loans with low LTVs less risky.

There are three ways to increase your LTV.

  1. Pay down your mortgage
  2. Make improvements
  3. Wait for similar homes to sell in your neighborhood

According to Fannie Mae, cutting your mortgage from 71 percent LTV to 70 percent could drop your rate by 125 basis points (0.125%). That's a savings of $8,000 over the life of a $300,000 loan. If your LTV is just above of any five-percentage-point tier, consider paying down the loan just enough to get to the tier below.

You can also make small improvements to increase your value, thereby lowering your LTV. Focus on bathrooms and the kitchen. These upgrades come with the most bang for the buck.

Lastly, stroll your neighborhood and look for homes that are on the market. A high-priced sale near you can increase your home’s value; appraisers base your home's value on sales of similar homes in the area.

2. Improve your credit score

In general, borrowers with credit scores of 740 or higher will get the best interest rates from lenders. With a score less than 620, it can be difficult to get a lower rate or even qualify for a refinance.

What’s the best way to improve your credit score? Pay your bills on time, pay down credit card balances, delay major new purchases, and avoid applying for more credit. All these things can negatively affect your credit rating.

It’s also wise to order copies of your credit report from the big three credit reporting agencies – Experian, Equifax, and Transunion -- to make sure they contain no mistakes.

You are entitled to one free credit report per year, per bureau.

3. Pay closing costs upfront

Closing costs can be substantial, often two percent of the loan amount or more.

Most applicants roll these costs into the new loan. While zero-closing-cost mortgages save out-of-pocket expense, they can come with higher interest rates.

To keep rates to a minimum, pay the closing costs in cash if you can. This will also lower your monthly payments.

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4. Pay points

Points are fees you pay the lender at closing in exchange for a lower interest rate. Just make sure that “discount points,” as they are known, come with a solid return on investment.

A point equals one percent of the mortgage amount – e.g., one point would equal $1,000 on a $100,000 mortgage loan.

The more points you pay upfront, the lower your interest rate, and the lower your monthly mortgage payment. Whether or not it makes sense to pay points depends on your current finances and the term of the loan.

Paying points at closing is best for long-term loans such as 30-year mortgages. You’ll benefit from those lower interest rates for a long time. But remember: that only applies if you keep the loan and home as long as it takes to recoup the cost.

5. Pit lenders against each other

As with any purchase, refinance consumers should comparison shop for the best deal.

This applies even if you have a personal relationship with a local banker or loan officer.

A mortgage is primarily a business transaction. It shouldn't be personal. A friend or relative who “does loans” should understand that.

Even if your contact suggests he or she can give you a lower rate, it can’t hurt to see what other lenders offer.

Lenders compete for your business by sweetening their deals with lower rates and fees, plus better terms.

And, don’t pre-judge a company just because it’s a banker or broaker. If a bank isn’t presenting tempting offers, consider a mortgage broker, or vice versa. Brokers may obtain a wholesale interest rate for you, which can be cheaper than the rates offered by banks. On the other hand, many banks offer ultra-low rates in an effort to undercut brokers.

You can benefit when lenders fight for your business.

6. Look beyond APR

Two mortgages with the same APR are often unequal.

For example, some mortgage rates are lower only because they include points you’ll have to pay upfront. Others may have an attractive Annual Percentage Rate (APR), but cost more overall because of various lender fees and policies.

It’s possible for two mortgages to have the same APR but carry different interest rates.

Shopping by APR can be confusing, so it’s best to focus on the total cost of the loan, especially the interest rate and fees.

It’s also important to check out competing loans on the same day because rates change daily.

7. Know when to lock in the rate

Once you’ve found a new mortgage that meets your needs, consult with your lender to pick the best date to lock in low rates.

Loan processing times vary from 30 days to more than 90 days, but many lenders will lock in the rates for just 30 to 45 days.

Avoid expensive lock extensions. An extension is needed when you don’t close the loan on time.

Ask your lender to determine the best day to lock the loan based on a conservative loan processing time frame. Otherwise, you may end up spending more money than you originally planned.

 

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