What to know about refinancing a mortgage
Getting a lower mortgage rate sounds great. But before you jump into a refinance, find out if it's right for you.
Refinancing the old homestead. If it’s something you’ve ever thought about, maybe now’s the time to take a closer look into it. Because, depending on your situation and current market conditions, it’s possible to reduce your monthly mortgage payments by hundreds of dollars, which could mean thousands over the course of a year. And really, who couldn’t use a little extra money in their pockets at the end of every month, right?
But, before you get too excited, you should know up front that refinancing isn’t right for everyone. In fact, there can be costs associated with a new loan that might make keeping your current mortgage the better option. Everyone’s situation is a little different, so we’ll take you through some of the most common to help you decide if it’s right for you.
First off, refinancing means replacing your old loan with a new one. It’s usually done for three main reasons. One of the most popular is to reduce your monthly mortgage payments. Another is to get a lower interest rate, which will save you money in the long run because you’ll be paying less interest over the course of the loan. And finally, a combination of the two.
So how do you know if it’s worth it? Well, as we said, one of the biggest and best reasons to refinance is to get a lower interest rate. If you can get a lower rate, and are able to make the same monthly payments you currently make, but are paying it toward your new, lower interest rate loan, you’ll typically save money every month. And when you add all that up over the length of your loan, it can mean some pretty significant cash in the long run. It’s that simple.
But really, it all depends on when and how you refinance your current loan. So if, for instance, your current 30-year mortgage of $200,000 has an interest rate of 6%, you’ll pay $231,676.38 in total interest if you hold the loan for its full term. Now if you can refinance to a lower rate of 4.5%, you’ll pay $164,813.32 in total interest over the life of the loan – that’s a difference of more than sixty-six thousand dollars. And who can’t appreciate an extra 66 grand in their bank account? But it only works if you keep the loan for the entire 30 years and pay it in full.
Now if you’ve had your current 6% loan for at least 5 years and 10 months or longer and you refinance the principal over a new 30-year term at 4.5%, the number won’t work in your favor. So you have to be careful. Because you’ll actually end up paying more interest over the life of the loan.
You should also factor in things like closing costs. Because they’re additional and usually added into the amount you owe on the loan, they can have an impact on whether refinancing is right for you. The best way to figure this out is to use a good online mortgage calculator that factors them in. You’ll find a good one in the refinancing section of bankofamerica.com
In addition to lowering your rate, another objective of refinancing may be to move into a fixed rate, because of the stability it provides. If you’re one of those people who has an adjustable rate mortgage, also called an “ARM” for short and your rate has either gone, or is about to go up, refinancing into a fixed rate will keep your monthly principal and interest payments the same, month after month, year after year, for the entire loan term. And that makes it easy to plan and budget.
Another good reason for refinancing is to shorten the length of your loan. The most common choice being to go from a 30-year loan to a 15-year loan. Let’s say you’ve got a 30-year fixed rate mortgage you’ve been paying off for the last five years. That means you’ve got 25-years left to pay. Well, this could be a good time to refinance to a 15-year loan. Do that and you’ll not only cut an additional 10 years off the time you owe, you’ll also save a ton in interest in the long run. Shorter term loans usually also offer a lower interest rate which is another good reason to change.
Check out these numbers. Pretend you were to refinance a 30-year fixed-rate loan for $200,000 into a 15-year fixed rate. Let’s also assume the interest rate on both loans is 4% and that there are no closing costs or fees. Your monthly payments would go up from $954 to $1,479. BUT, if you could comfortably afford this increased monthly payment each month, it could save you a bundle in interest over the course of 15 years. To the tune of 77 grand. That is huge!
So while there was a significant monthly payment increase, if you weigh that against the savings in interest and time, it could be to your benefit to shorten the length of your mortgage.
While we’re on the subject of loan length, it’s also possible to push out the length of your loan. So say you originally took out a loan for 30 years and you’ve been paying it off for 10 years now. Well, you could refinance and start over with a new 30-year mortgage. The benefit being that it’ll reduce the amount you owe every month, thus freeing up funds for other purposes.
The negative is that instead of having only 20 years left to pay off your loan, you’ve restarted the clock and now won’t pay off the loan for another 30 years. If you keep the loan for the entire 30 years, you’ll probably pay more in overall interest than if you kept your original loan. Again, run the numbers to find out if extending your loan term is the right move for you.
You can also refinance if you need some extra cash and want to borrow from the available equity you’ve built up in your home. It’s called a cash-out refinance. It’s good when you need significant funds to pay for things like home improvement projects or to put a kid through college. Then this could be an option for you. But it does come with downside. With this type of loan, you’re taking out a new mortgage to replace your old one — so you’ll be required to pay closing costs. Also know you’ll be dipping into the equity you’ve built up, and if you were to sell, what you’d net would be reduced by the amount you borrowed. Not to mention that you’ll probably extend the time it will take to pay off your loan, which means paying more in total interest costs.
It’s important to note that a cash-out refi is not the same as a home equity loan, though both are taken out to get access to cash, and both have limits on the amount you can borrow in relation to the value of your home. The major difference being a cash-out refi is a new loan that replaces your existing mortgage, while a home equity loan is a new loan that you take out in addition to your existing mortgage.
Regardless of the reason you’re considering a refinance, there are a couple things that everyone should keep in mind, no matter what your situation or objective. And that’s that there are costs that come with the process — so it’s important to evaluate the fees you could be charged to make sure it’s worth it.
These closing costs typically include an appraisal, a title search, title insurance and recording fees, plus a variety of other processing charges. You may also be required to establish an escrow account for property taxes and homeowners insurance. And it’s likely that you’ll be required to pay up front interest from the day that you close until the end of the month in which your loan is closed. If you don’t have the cash on hand to pay these closing costs, ask your lender if financing your closing costs is an option. And once again, this is a good time to use an online mortgage calculator to make sure you understand the cost of financing your closing, and if it’s even worth it to you.
One other consideration is whether or not to pay points, which basically means prepaying interest to reduce the interest rate for the entire loan term. This can make sense for some borrowers, but certainly not for all. To see if points are right for you, ask your bank representative or use an online refinance calculator.
Even with closing costs, if interest rates are currently better than when you took out your mortgage, it’s definitely worth your time to see if you can save some money. You can find the latest rates in your local newspaper or online at places like bankrate.com. Then crunch some numbers to see what your financial situation could look like. There are plenty of online refinance calculators that can help with the math. The Federal Reserve’s website at federalreserve.gov/pubs/refinancings even has a worksheet that can help estimate how long it will take you to break even and to recover all of the refinancing costs we just went over.
Finally, remember that not everyone qualifies for a refinance. In fact, as standards continue to get tougher, you’ll have to demonstrate that you can afford the payment along with any other debt you have.
It’s a lot of information to digest, for sure. But as long as you determine what your situation is, research current interest rates and fees, examine your mortgage documents and dig into the numbers, it should become clear whether you can benefit from refinancing. Especially when it may be possible to save thousands of dollars over the life of the loan, if that’s ultimately what you’re after. It could definitely be worth the time and effort. In fact, it could be a nice gift that you give to yourself every month.
Key Takeaways: Look into refinancing your mortgage to see if you can lower your monthly payments, lower your interest rate, replace an adjustable rate mortgage (ARM) with a fixed-rate one or if you want to tap into the equity you’ve built up over time.
Research the fees you’ll have to pay to see if refinancing makes sense for you; start by using the Federal Reserve’s break-even worksheet.
See how much a refinance could save you by looking up current interest rates in your local newspaper or online and using an online refi calculator.
Watch our video “Understanding different mortgage types” to see what kinds of mortgages might be available to you.
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