Should You Refinance Your Home Mortgage?

By Pinyo, on February 9, 2009

The other day, I wrote about getting cash through reverse mortgages.  Today, I want to explore refinancing to access money locked up in your home equity. I think it’s a good idea to learn about these options in face of the economic crisis and record high unemployment rate.  You never know when your home equity will come in handy.

What Is Home Mortgage Refinancing?

Home mortgage refinancing, or home loan refinancing, is basically the process of taking out a new mortgage with new term and interest rate to pay off the existing home loan.  You can either do this with your existing mortgagor (mortgage lender), with a different financial institution, or you could go through intermediaries like LendingTree to have several lenders compete for your loan to get the lowest mortgage refinance rates.

Why Should You Refinance Your Home Loan?

There are several reasons why refinancing might be right for you.  Usually, people refinance their home for one or more of the following reasons:

• Lower your overall costs – The main reason why people choose to refinance their mortgages is to lower their borrowing costs by taking advantage of the lower interest rate.  Incidentally, this is why more people are refinancing their home loans when interest rates are low, such as now.
• Lower your monthly mortgage payment — Another reason to refinance is to lower your monthly payment and improve your cash flow, so that you’ll have more money available to do other things.  You can lower your monthly mortgage payment by taking out a similar loan at a lower interest rate, or taking out a longer-term loan — i.e., refinancing the current loan with 20 years left to a new 30-year fixed rate loan.
• Reduce your risk — Refinancing can also be used as a risk management tool. For example, if your original home loan is an adjustable rate mortgage (ARM), you could refinance to a fixed rate mortgage to protect yourself against sudden rise in interest rates when the initial discount period expires.
• Raise cash – Refinancing can also be used to unlock your home equity and gain access to cash.  This is called a cash-out refinancing. Specifically, you are taking out a larger loan than you currently owe, and keeping the difference in cash.  Money raised from refinancing could be used for different purposes; for instance, for home renovation, to pay off high interest debt such as credit card debt, to pay for major expenses, or for investment purposes.
• Shorten your mortgage term – Refinancing isn’t always about lowering your monthly payment. If you are earning more than you used to, it may be worthwhile to covert your longer-term mortgage to a 15-year loan.  This is generally better than prepaying the loan, because 15-year loans usually have lower interest rates than a longer-term loan.  This will help you pay off your home loan much faster and save you tens of thousands of dollars in interest payments.
• Eliminate your Private Mortgage Insurance (PMI) — If your equity increased above 20% due to the rise in your home value, refinancing could be an option to get rid of your PMI if you can’t persuade your lender to drop the mortgage insurance.  Getting rid of your PMI could save you $100 or more a month.

When Is The Best Time To Refinance Your Home Loan?

Usually, the best time to refinance your home mortgage is when interest rates are low.  Due to the costs associated with refinancing, the current interest rate should be at least 1% lower than the interest rate on your existing loan for refinancing to make sense.

Moreover, you may also consider refinancing your home if:

• Your creditworthiness — i.e., your credit score — improved enough to qualify for a better interest rate.
• Your financial situation changed significantly.  For example, you want to lower your monthly payment because it’s straining your budget.
• Your adjustable rate mortgage teaser rate is expiring and you expect your interest rates to rise.

The Costs of Refinancing

However, it’s important to remember that refinancing is not a free lunch.  There are closing costs associated with refinancing similar to the closing costs that you paid when you first bought your home. Closing costs usually include fees associated with: survey, appraisal, title search, title insurance, realty transfer taxes, legal services, messenger or delivery services, document copying, etc.

You may also choose to pay points to get a reduced interest rate on your new loan.  A point represents 1% of the total loan amount. For example, one point on a $100,000 mortgage costs $1,000. However, you are not required to pay points.

In essence, you are selling the house back to yourself all over again.  As such, you have to stay in your home for a few years after refinancing to make it worthwhile. You can use this home refinancing calculator to help you determine your break-even point and see if refinancing makes sense for you. The rule of thumb is to refinance when you can recover the cost of refinancing within 24 months.

When Refinancing Does Not Make Good Financial Sense?

Before I conclude this article, I just want to say that mortgage refinancing is generally beneficial if done correctly and for the right reasons.  However, there are things that you must watch out for and make sure that you do not refinance for the wrong reasons.  For example:

• You may not want to refinance if your new mortgage payment will be more than 28% of your income.  This will put to much strain on your cash flow.
• Think carefully before refinancing to consolidate unsecured debt such as credit card balances. A refi home loan is a secured debt and if you don’t change your spending habits in the process, you could end up losing your home.
• Do not refinance to buy depreciating assets, especially a car or electronics.
• Do not refinance to pay for non-essential expenses, such as a vacation or a wedding.
• Consider other options carefully before using refinancing your home to pay for your child’s college education.

In addition to reverse mortgages and mortgage refinancing, there are a few other ways to unlock your home equity. I will be exploring these other options — i.e., home equity loan and home equity line of credit (HELOC) — as part of this series in the near future.

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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