If there is little or no cost, refinancing
can make sense even if rates have dropped only marginally.
THE MOST LIKELY REASONS TO REFINANCE
The rules on refinancing have changed greatly over the years because of the availability of ‘no-cost’ and ‘low-cost’ mortgages, where the lender pays some or all of the costs of refinancing. In some situations it does make sense to refinance even if you have to pay closing costs. Depending on the situation, there may be financially sensible alternatives to a mortgage refinance.
The most likely reasons to refinance and what to consider:
1. Lowering your interest rate:
To determine whether it makes sense to refinance at a lower interest rate takes careful thought, and good guidance from a mortgage professional.
Since it is now possible to refinance your current loan balance with a no-cost loan, where the non-recurring closing costs are paid entirely by the lender (not rolled into the loan amount), it can make sense to refinance after only a modest decline in interest rates. There is no break-even point if you don’t have to pay any closing costs or increase your loan amount – you start saving money immediately, in month one. However, a loan offer which has the closing costs paid by the lender will always have a higher interest rate than one in which you pay the closing costs. Using the quick calculation in the next paragraph when comparing options will determine which is the best course of action for you based upon your financial goals and plans.
If you, not the lender, are paying all or a portion of the closing costs, divide the cost you are paying by the amount the refinance will save you each month (the difference between your current mortgage payment and the new mortgage payment). That will determine your ‘break-even’ point, how many months until the aggregate savings on the new loan payment are greater than the cost of the refinance.
You can refinance and reduce your monthly payment by lowering the interest rate, paying down principal and lowering your loan amount, or switching to an interest only mortgage. If you are planning on refinancing just to lower your loan amount, and the interest rate would not be appreciably lower, contact your current lender and ask about a recast. Most lenders will recast your current mortgage to reflect a new, lower principal balance, which will give you a lower payment. For example, if your current loan has 220 months left with a balance of $410,000, and you have the cash to pay it down to $300,000, for a small fee the lender will give you a new, lower payment, based on 220 months and a loan amount of $300,000. Many lenders will only allow a recast once during the term of a loan.
2. Converting from an ARM to a fixed rate loan:
Many borrowers took out an ARM planning on refinancing into a fixed rate mortgage in the future, before their ARM became adjustable. If you have an ARM refinancing into a fixed can be a wise move.
Rates have moved down in fits and starts since the early 1980s; anyone who had an ARM saved a great deal of money over the last 30+ years. However, the past does not guarantee the future, and ARMs may not be the better option going forward. The question is your risk tolerance – are you willing to accept the risk that your interest rate might increase by 5 or more points in the future in exchange for a lower rate until that happens? If you do opt for the fixed now and interest rates drop lower in the future, you can always refinance again at the lower rate if you qualify.
3. Taking cash out:
The alternative to a cash-out refinance is to keep your current loan and apply for a home equity line (HELOC). One consideration with a HELOC is its structure: the interest rate on a HELOC adjusts monthly and can move very quickly up or down during times of economic volatility. Weigh the inherent risk of a much higher interest rate on the credit line if rates rise. The lifetime interest rate cap on a HELOC is high, usually 18%, and the payments are interest-only for the first ten or fifteen years. What would your payment be at 10%? At 18%? This is an important calculation if you are pondering refinancing your current mortgage at a higher interest rate in order to take cash out. Also, some HELOCs become due in 10 or 15 years, and if you are unable to get a new HELOC or refinance at that time, you can be in a difficult situation. It may make financial sense to keep a lower interest rate on your first mortgage and take the interest rate risk on a HELOC, especially if the HELOC amount is relatively small compared to the primary mortgage, but consider the risks.
4. Reducing your loan term to pay off your mortgage sooner:
There are two very important factors to consider. First, even though a 15-year fixed has a lower interest rate, your payment will increase sharply. A rule of thumb is that a 15-year loan will increase a 30-year loan payment by about 40%. For example, if you are being offered a 30-year fixed with a payment of $2500, the same loan amount with a 15-year amortization would be around $3500 per month. Many borrowers who would like a 15-year fixed won’t qualify at the higher payment. The second important consideration is flexibility. A $400,000 15-year fixed mortgage at 3.75% has a payment of $2908; a 30 year would have a higher interest rate, closer to 4.50%, but a much lower payment of $2026 per month. Even if you can afford the 15-year payment now, you should consider whether you want to lose the flexibility of having a smaller payment. A great alternative: opt to make the 15-year payment of $2908 each month on the 30-year mortgage rather than the required $2026, and that 30-year mortgage would be paid off in 16 years and 2 months. You would have the flexibility in a challenging time to make the smaller payment if that were necessary; or, if circumstances are favorable you make the higher payment and have your mortgage paid off in just a little over 15-years.
5. Consolidating a second mortgage:
The primary reason to consolidate a HELOC, and a very good one, is to avoid the possibility of a sharp increase in the interest rate. You have to walk carefully through the math on this if you are going to increase the rate on your first mortgage in order to fix the rate on your HELOC balance. If your HELOC balance is relatively small, even if rates go very high, it might not make sense to raise the rate on the first mortgage to fix the HELOC. Although the HELOC could go to 18%, historically it is very, very unlikely that it would remain there long. A good rule-of-thumb: figure the payment on your HELOC at 10% and add it to the payment on your current first mortgage. If that number is lower than the payment on a new first mortgage which combines the two, stay with what you have.
6. Dropping mortgage insurance:
You can use a refinance to terminate mortgage insurance (MI) if your loan balance is now 80% or less of the appraised value, or you are able to pay down the principal balance to that level. If interest rates have dropped, this makes sense. If interest rates are higher, you may still be able to drop the MI. After two years, some lenders will cancel mortgage insurance if you can provide an appraisal showing that the loan-to-value has dropped to a level that the lender is comfortable with, 80% or less depending on the loan program and/or the lender. Contact your lender to find out specific guidelines. In order to drop the mortgage insurance on FHA loans originated after May of 2013, you have to refinance, regardless of property value.
7. Taking a co-signer off a mortgage/title:
Refinancing is usually the only way to take a co-borrower off of a loan. For all loans sold to Fannie Mae, Freddie Mac, FHA, and VA, refinancing is the only choice. Some banks and credit unions may consider allowing one borrower to come off the loan if the remaining borrower is very strong financially. However, many of the banks which do group TIC loans will allow a new borrower onto a loan to replace a borrower who is moving on, if credit qualifications are met and fees are paid.