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Mortgages Part 7: Refinancing

Refinancing

Last article we continued our discussion on mortgages when we went over Private Mortgage Insurance (PMI). When all the posts in the series are complete, you should have an understanding of mortgage types, structure, rates, points, fees, mortgage insurance, and refinancing. This week we are going over refinancing.

What is Refinancing?

Simply put, refinancing is replacing your current loan with a new one. The new loan will pay off your current debt, and you now have new terms for a new loan. Typically people refinance their home because the market allows for a considerably better deal than they currently have. There’s no benefit, and can even be detrimental, to refinancing if the new loan isn’t a much better one.

Why Refinancing Can be a Bad Idea

Refinancing isn’t always a great idea. There are instances where the new terms could actually put you in a higher financial risk. In the next article we will go over break even times, but it’s important to weigh the benefits against how long it actually takes to recoup the cost of refinancing.

Refinancing to a lower interest rate but for the same term could actually cost you thousands in interest.

Higher Interest Paid

If you are not shortening the term of your loan, even with a lower interest rate, it’s possible to actually end up paying more in interest over time. For example: You have a $100,000 loan at 4.5% that you have been paying $507 a month for 5 years. You now have a balance of around $91,000 and $60,849 in interest left to pay. There’s an option to refinance and wrap closing costs into the loan for $92,000 at 4%. Now your monthly payment is $439, lowering it by $68 a month! However, over the next 30 years you are going to pay over $66,000 in interest, so it turns out it’s not a great deal.

Transaction Costs

In the example above we had some closing costs wrapped into the loan. This is not uncommon. When we go over break even times, you’ll learn that keeping in mind how much the transaction is going to cost you is important. Even if paying it upfront, it could be more expensive than it’s worth.

Reasons for Refinancing

As previously stated, you wouldn’t normally refinance unless the terms of the new loan are considerably better than your current loan. Refinancing is a time consuming process and can be expensive if the payoff isn’t there. So why do people refinance their loan?

Shorten the Term of Your Loan

Most people have a 30 year mortgage on their home. Over time conditions of employment and availability of money changes. So if you get to a point where you could afford a higher payment, it could be worth getting a 15 year mortgage to replace your 30 year one. Another alternative to this is to pay your 30 year as if it were a 15 year loan. If the conditions of a new loan isn’t worth the hassle or money, you can just make extra payments on your current loan. Plus it offers flexibility in the event you need to access those funds in the future.

refinancing

Lower Monthly Payments

As you build equity in your home, a newer loan would offer a lower monthly payment due to the lower principal borrowed. It’s important to keep in mind that when you refinance, you are resetting the clock on your loan. So if you have a 30 year mortgage that you have been paying for 10 years, getting another 30 year will have you paying on that home for 40 years. Often you can switch to a 20 year or a 15 year and still lower your monthly payments.

Changing Loan Types

If you are someone who is on an ARM (refer back to Mortgages Part 1: Common Types of Mortgages), refinancing could get you out of having rate increases and lock in the current market rate. Some people will get an ARM thinking they will only be in the home for a couple years and sell before the balloon kicks in. However, if you end up staying in the home, a refinance can get you on a fixed rate and avoid those increases in the future. This is especially beneficial when the rates are low.

Save Money

The obvious reason, refinancing can save you money on interest costs. If you are in that balloon mortgage, or interest rates have dropped, then refinancing can save you money on interest payments. The larger the amount is borrowed and the longer you have remaining on the laon, the more beneficial this can be. This paired with the previously mentioned reason can free up money every month and give you more opportunity to use it for something better.

Final Thoughts

Refinancing can seem like a great idea. There’s plenty of reasons why it could be. But there are a lot of factors that come into play when refinancing. It’s important to talk to an experienced loan officer and financial advisor any time you are thinking about taking such a large action. Plans change and so do the conditions of our lives. So remember that just like things changed making a refi look good, things could change that could make it bad too.

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