Lenders paint a rosy picture of refinancing, but do you really know the truth about refinancing your mortgage? Taking the time to learn more about refinancing can save you thousands of dollars – as well as prevent unnecessary stress.
What Is Mortgage Refinancing?
When you refinance your mortgage, your original loan is paid off through the refinancing process and you are left with the new refinanced loan. There are many reasons why people refinance their mortgages, but unfortunately not everyone considers all of the factors involved. This is partly because lenders and mortgage servicers want you to refinance, so they may not provide both sides of the story. Be sure to find out the truth about refinancing your mortgage before you make your decision.
Reasons To Refinance Your Mortgage & The Truth Behind Them
Lower Interest Rate
Truth: If your credit score has increased since your first mortgage or lending conditions have caused interest rates to drop, you could be able to refinance to a lower interest rate. Although a lower interest rate usually means you’ll have a lower monthly payment, it does not guarantee that you will be saving money in the long-run. If you extend the term of the loan, you’ll most likely be paying more in interest over the life of the loan. This happens if you get a 30-year mortgage in 2010 and then refinance with another 30-year mortgage in 2015. You’ll pay off your mortgage in 2045 instead of 2040 – that’s an extra 5 years of interest.
Switch To Fixed-Rate Loan
Truth: Many people with an adjustable-rate mortgage, or ARM, want to have the comfort of predictable payments, such as with a fixed-rate mortgage. Fixed-rate mortgages provide more stability than ARMs, however depending on market rates ARMs can cost more OR less than fixed-rate mortgages. Be sure to fully understand adjustable-rate mortgages before refinancing to a fixed-rate mortgage.
Changing The Term of The Loan
Truth: There are trade-offs that you should be aware of if you shorten or extend the term of the loan by refinancing. If you go from a 15-year mortgage to a 30-year, your monthly payment will be lower but you will pay more in interest due to the higher interest rate. On the other hand, if you go from a 30-year mortgage to a 15-year mortgage, you will get a lower interest rate and pay less in interest, but your monthly payment will be higher. The risk with this is if your income changes and you are no longer able to afford the higher monthly payment. Another option is to make additional payments rather than changing to a shorter term mortgage if you are looking to save on interest. Learn more about paying off your mortgage early in our article.
Eliminate Mortgage Insurance Premium
Truth: For most government backed mortgages, refinancing to a conventional loan is the only way to get rid of your mortgage insurance premium. Federal Housing Administration, or FHA, mortgages newer than April 1, 2013 require refinancing in order to eliminate mortgage insurance premiums. For conventional mortgages, you don’t need to refinance to get rid of private mortgage insurance after you have enough equity in the property.
Borrow Money With A Cash-out Refinance
Truth: A cash-out refinance allows you to borrow money against your home equity. You will receive a check at closing and the amount will be added to the principal of your mortgage. The interest rate may be lower than other financing options, however you will reduce your home equity, pay more in interest and likely extend the term of your loan. If you are interested in refinancing for this reason, you should consider alternative lending options as well.
Cost of Refinancing
According to the Federal Home Loan Mortgage Corporation, more popularly known as Freddie Mac, the average closing cost of a refinance is about $5,000. This includes government recording costs, appraisal fees, credit report fees, lender origination fees, title services, tax service fees, survey fees, attorney fees and underwriting fees. Since closing costs are so expensive, it’s vital to calculate the break-even point of your refinance (more on that below).
No Cost Refinance
If you hear the words “no cost” and “refinance” together, then it is a clear red flag. There is no such thing as a no cost refinance. Someone has to pay closing costs, which means that those costs are baked into your mortgage and you’ll end up paying for them down the line. Do yourself a favor and avoid so called no cost refinances.
Calculate The Break-Even Point of Refinancing
The break-even point of a mortgage refinance is the amount of time it takes for the monthly savings to equal the cost of refinancing. You can use the loan estimate provided by the lender to find out the cost of refinancing.
To calculate the break-even point, you divide the total loan costs by the monthly savings. The monthly savings is the difference between your current monthly mortgage payment and the new one. For example, if your current mortgage payment is $2,000 and the new monthly payment after refinancing is $1,800, then the monthly savings is $200. If the total loan cost is $4,000 then $4,000/$200 = 20 months to break-even. If you don’t plan on staying in your home past the break-even point, then you shouldn’t refinance since that’s when you will start to save money.
Try out our break-even point calculator to find out how many months it will take you to start saving money after refinancing:
Break-Even Point Calculator
Keep in mind the terms of the mortgages that you are comparing. If you extend the term of your mortgage then you may have monthly savings, but that doesn’t take into account the interest for the term of the loan. Knowing the break-even point of refinancing is really just to help you understand if you will live in the property long enough for refinancing to be worth it.
The Bottom Line
There are pros and cons of refinancing, but it’s important to know the truth about refinancing your mortgage prior to making a decision. We’re hoping that if you read this much you have learned enough to either make an informed decision or do further research.
Don’t take this decision lightly because it could cost you thousands or tens of thousands of dollars in the long-term. Take your time so that you can confidently choose.
Not sure you understand what’s going on behind the scenes of your mortgage? Check out our article, Understanding Your Mortgage: What’s Behind The Scenes, to learn more.
Financial freedom begins with good habits.
Rebecca & Tiago, theloadedpig.com