This post was written by Dylan Clegg.
It was not so very long ago that refinancing a mortgage was an easy decision. Rates were low and values seemed ready to rise forever. Millions of homeowners were cashing in on their growing equity, often walking away with a double win: lower monthly payments and a nice big check. It was the best of all possible real estate worlds.
The mortgage landscape has changed a great deal since those halcyon days, and today’s homeowner needs to look more carefully at the implications of refinancing an existing loan. There are still many reasons to refinance, but there are pitfalls to consider as well.
Good Reasons to Refinance
In almost every case, the best reason to refinance is to save money, and the simplest way to save is with a lower interest rate. If rates will be significantly lower on a new loan than they are on an existing loan, savings naturally follow. For example, a loan of $100,000 that carries an interest rate of 5 percent costs $5,000 in interest every year. If the rate can be reduced to 4 percent, that represents a saving of $1,000 annually.
Every prospective borrower does not get the same interest rate. Instead, the rate paid by a given borrower is customized according to that borrower’s specific circumstances. The biggest influence on the rate is the creditworthiness of the borrower. If your credit score has improved since you last took out a loan, there is a very good chance that you can get a lower rate now.
You may also be able to save because of changes in things you cannot control. If the amount of the loan was high when the property was purchased, that loan may have been categorized as a “jumbo” loan, a category that comes with higher rates. The cut-off for jumbo loans changes every year, though, and you may find that your loan amount no longer falls within jumbo parameters. In that case, it can make sense to investigate a conventional loan at a lower rate.
Saving money may be the single best reason to refinance, but not all refinances are motivated by savings. Borrowers often want to tap some of their home equity, whether to pay bills, finance an education, make improvements to the property or for any of a hundred reasons. This can be a perfectly valid choice, but borrowers should remember that they are using their homes as collateral and consider the risk involved.
Good Reasons to Think Twice
Regardless of interest rates or property values, borrowers should know that a refinance resets the mortgage clock. If an existing loan has a 30 year term, a new loan will start from scratch. If a loan has been outstanding for five years or more, the borrower is starting to see more principal included in each payment. With any new loan, the first few years are almost entirely devoted to interest payments.
The second issue to consider is whether the decrease in rate is enough to make the transaction worthwhile as a whole. Almost all loans have closing costs. If those costs are high, they can outweigh any savings that come from a lower interest rate.
The borrower’s plans play a part in the tradeoff between closing costs and rate. If Borrower A pays $5,000 in closing costs while saving $1,000 per year on monthly payments, he will not recoup those closing costs if he plans to sell the house next year. Borrower B, however, who plans to be in the home for the next 20 years, will see savings after the first five years and will save enough over the life of the loan to more than make up for the initial costs.
Private Mortgage Insurance (PMI) can also be a factor. PMI is a monthly cost that is typically applied to mortgages when the loan-to-value ratio exceeds 80 percent. A borrower may not have faced PMI when he purchased the property, but, if the house has lost value, PMI may suddenly be required.
Even if they can be approved for a mortgage, borrowers who have had recent credit issues may run into problems. Lenders save their lowest rates for their most creditworthy borrowers. Borrowers with credit issues often find themselves faced with higher rates when trying to refinance, a situation that is the reverse of the one facing borrowers who are refinancing with improved credit scores.