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When Should You Refinance Your Mortgage?

 

You want to get out some of the equity in your home or you want to lower your mortgage payments; should you refinance your mortgage?

The question is asked often. Often by people who know the answer but want reassurance.

If you’re not among those, if you’re among those for the first time asking, here’s some information for you that might be useful.

Types of Mortgage Refinance

As mentions above, people refinance for 2 reasons.  When they want a better interest rate, it is called Rate-in-Terms Refinance (it would be called the same even if the rate were worse, but why would you do it?).  It is called cash-out refinance when they want to access their home equity.

Rate-in-Term Refinancing

In this case, it is easy to know when to refinance: when the mortgage payment is lower, right?

Actually, it’s a bit more complicated.

Because refinances come with costs.  If you, the homeowner refinancing, are paying the costs, you should take into account those costs when deciding.

Though not as large as the closing costs on a purchase, refinancing costs are not peanuts.  Specifically, borrowers pay for appraisals, registering the loan, and title.

Rate-in-term refinancing can be done to reduce the interest rate, to move from a mortgage program that has insurance premiums to one that does not, to move from an ARM loan to a fixed-rate loan.

The powers that be (FHA, for instance) do not allow refinancing mortgage loans where the monthly payment is not reduced by at least 0.5%.  A reduction in monthly payments of 0.5% means different things, depending on how long borrowers will keep the new loan (and the costs of getting said new loan).

You save a lot more dollars if you keep the new loan for 20 years than if you keep it for 3.  Of course, the dollars saved in the last few years of the 20-year term will have less buying power than those saved in the first.

Advanced Mortgage Refinance Calculators?

You may, of course, use a refinance calculator, even an advanced mortgage refinance calculator; but the math is not hard, refinancing calculators are not required.

To start, you need to know:

  1. the principal and interest you are paying currently
  2. the principal and interest of the new loan
  3. how much the refinancing will cost you.

Then, you need to do a bit of not-too-advanced math.

Deduct the new mortgage principal and interest part of your current mortgage principal and interest from the principal and interest of your old mortgage to get your profit.

Divide your closing costs on the new mortgage by your profit to figure out how long it will take you to recoup your closing costs.

Do you like how long it takes to recoup the closing costs and start actually profiting?  If yes, proceed.  If no, do not.

Refinance examples:

If your current principal and interest is, for example, $1000 per month and the new monthly principal and interest is, say, $877, then, you’d be lowering your monthly payments by $123 (assuming neither loan has mortgage insurance).

If your closing cost are, for instance, $1100, it would take you 8.9 payments to recover them.  So, you start really profiting before the 10th month payment mark.  Some people like that, some do not.  Do you?

What if the difference between the refinance and existing mortgage payments is only $30, for instance, while the closing costs are the same (and neither loan has mortgage insurance)?

1100 divided by 40 equals: 36.66 months. You start profiting after 3 years.  Is that good enough?

What if, in both examples, you plan to hold onto the new loan for only 4 years? What if you plan to hold on to it for 20 years?

Refinacing and ARM into A Fixed-Rate Mortgage

Every time someone refinances these days, the powers that be (the FHA, for instance) want to see a tangible benefit.  Since most ARM’s are for short-ish periods of time but their interest rates can go up several points in a couple of years, converting an ARM into a fixed-rate loan is seen as being a tangible benefit.  And it often is…

The powers that be do not take into account how long borrowers plan to stay into an ARM loan, though.

Refinance Example

A borrower takes out a loan that’s going to have a fixed-rate period of 7 years, then the rate adjusts, once a year, up to 2% a year.  The initial (fixed) rate is 3.750%.  The most the interest rate can rise is 9.75%. (The borrower could have gotten into 30-year,  fixed-rate loan at the time with a rate of 4.375%.)

Clearly, the rate for loan amortized over 30 years would have to go below 3.750% during the fixed rate period for a refinance to start making sense.

But what about later?  Should this borrower refinance into a 30-year fixed loan towards the end of the 7th year?

That would, of course, depend on the interest rate that they could get at the end of the 7th year on that 30-year loan.  Or how high the payments are (reducing principal enough during the fixed-rate period can make keeping the ARM a better choice than refinancing as the new payments would be based on the principal at the time the rate resets).

Worst case scenario, the rate on the ARM during the 8th year is 5.750%.  To be, mathematically, profitable, the 30-year fixed would have to have a rate of at least 5.699%.  For practical reasons, it would have to be low enough that the borrower would recoup closing costs on the new loan within a period of time the borrower likes.

Cash-Out Refinance of Mortgage Loans

Cash-out refinances are riskier; lenders, therefore, want interest rates that are higher than those of rate-in-term refinaces.

Whether you should refinance a mortgage loan of not depends on why you want to get cash, when you want to get it and what other options you have.

Sometimes, refinancing costs you less; sometimes keeping the existing mortgage and taking out a HELOC makes more sense, sometimes keeping the existing mortgage an borrowing the amount you need from a friend or relative or other third party makes sense.

The options are many.  You can get the new loan in one lump sum, upfront; you can get it as a line of credit (with some part upfront or no money upfront; with interest payments only for a while or interest and principal).

Generally speaking, the 2nd loan is going to have a higher interest rate.  However, that higher interest rate is against a smaller amount, so it and the payment on the original mortgage might be smaller than the payment on a new refinance loan.

Once you know how much money you want, you should talk to a loan officer.  Yes, you can get the calculations online, there are plenty of mortgage calculators to be found.  A loan officer, though, would be better (you don’t get white hair and you can get answers to all kinds of questions).

Other Mortgage Refinance Thoughts

By the way, it is possible to refinance a mortgage loan and have no closing costs (that is to say, you don’t have them, someone else pays them) but it’s hard to find a lender that will be willing to do that.

It is possible to refinance a mortgage loan if you’ve missed a payment or two recently.  I have yet to come across a lender that will refinance your loan if you’re behind.

It is possible to refinance a reverse mortgage.

You can refinance it into another reverse mortgage or into any other kind of mortgage, assuming there’s enough equity and the property and you meet the criteria of the lender that’s going to give you the new loan.