Removing the Mystery from … When to refinance?
When does it make sense to refinance?
There are a number of reasons why a borrower might want to refinance a home loan – some obvious, some not so obvious.
The most common reason is to take advantage of a lower interest rate. The old rule-of-thumb used to be that you didn’t refinance unless the new rate was at least two points less than the old rate. But this thinking is hopelessly out-of-date and potentially very costly. This is due in large part to the popularity of the no closing cost loan.
With a no closing cost loan, it may be profitable for you to refinance even if your rate drops by 1/8%. This is because obtaining the new loan doesn’t cost you a single penny (if you define a no closing cost loan the way Apple Street Mortgage does) and you can lower your monthly payment without cash risk. Of course this may have the effect of extending your loan back out to its original duration - but you don’t have to! Instead, you can continue to make the same payment as you did with your old loan. Since your new required payment will be less than your old required payment, you will be effectively prepaying principal and you will build equity faster and ultimately pay your loan off more quickly.
As appealing as the no closing cost loan may be, it may not be the best way to go because the no closing cost loan is offered by the lender in exchange for a higher interest rate. While this pays off for you if you don’t plan on keeping the loan for more than a few years or so, you can win in the long run by paying closing costs and even paying discount points. But this carries considerable upfront cash risk and you probably won’t want to go this route unless you can improve your rate by a considerable amount. Many variables are involved in figuring out what is best, but we’ll look at your specific situation with you so that you can make an informed decision
Debt consolidation is one of the biggest benefits of refinancing. You may have a credit card or two that carry large balances and a 20% interest rate (ouch!) along with a car loan or second mortgage that hindering cash-flow. Consolidating all of these debts into one low interest rate loan with tax benefits may make a lot of sense.
Since we mentioned extending the life of your loan back out to its full term with a refinance, it is worth pointing out that it may be cost effective to do so even if your rate does not improve – or even gets worse! The rationale here is that, depending on how many years you have left on your current loan, you may be able to lower your monthly payment simply by extending its lifetime which can increase your current cash-flow.
For example, let’s say you took out a $200,000 30 year fixed rate loan twenty years ago at a rate of 6% (never mind for a moment that rates weren’t this low 20 years ago!). Today you would owe about 100,000. If you refinance into another 30 year loan at an even higher rate of 6.5%, your monthly payment is cut almost in half. Granted, you’ve just extended your loan from 10 years back out to 30 years, and you’ve increased your interest rate, but if you need improved cash flow, this is one way to get it and your new rate represent a cheap way to get some more cash. This is certainly not something that you would want to rush into without careful consideration, but it’s an option. Again, we’ll help you analyze your situation for you.
One of the more common reasons to refinance is to get cash out of the equity in your property. If you need $40,000 to refinish your basement, a so called “cash-out” refinance may be the way to go. This of course also has pros and cons that must be weighed against a number of things including taking out a second mortgage.
You may wish to refinance in order to change your loan product. For instance, you may have an Adjustable Rate Mortgage or ARM which is due to adjust soon and you believe that a fixed rate may be safer, even if the fixed rate is higher than what you are currently paying on your ARM. Conversely, you may currently have a fixed rate and you plan to sell your property in the next few years. In this case, it may be sensible to refinance into a lower rate ARM product. Or you may have a 30 year loan and you can afford to make the payments on a 10 or 15 year loan that carries a lower rate. Perhaps an interest-only product is the right loan for you to increase cash flow.
Another reason that you might refinance is to “reset the clock” on your ARM. Let’s say that you have a 3/1 hybrid ARM that is due to adjust in the next year and rates are headed up. By refinancing into the exact same 3/1 product, you extend the adjustment period back out to three years, giving you a couple extra years of your lower payment before it is due to adjust. Maybe you can even get into a safer 5/1 ARM at the same rate as your old 3/1. It just depends on where rates are relative to your original loan and your individual circumstances.
Still another benefit to refinancing is to remove a coborrower from the debt obligation. This is sometimes desirable or required in the case of a divorce where one ex-spouse is awarded a property and the other ex-spouse does not wish to be obligated on the current loan. A refinance can have the desired effect.
Summary
There are many reasons to refinance and even more ways to do it, but the method that you choose can have far ranging effects on your total financial picture. We’ll gladly visit all of the reasonable possibilities for you (including perhaps doing nothing if we believe that that is what makes the most sense for you). We’ll also keep track of your current loan terms, watch rates for you, and let you know when we think it’s time for a (re)financial checkup!