In the past few months, we have talked with a good amount of people who have been asking or thinking about refinancing. Most of these people have been interested in locking in a lower interest rate, but the motivation for refinancing can vary from person to person. In today’s post, we will take a look at some of the more common reasons for a mortgage refinance and briefly explain what each reason can do for a borrower. Lastly, we will discuss “free refinancing” and what that actually means when you take a closer look at it.
What is refinancing?
A mortgage refinance is the act of replacing your existing loan with another loan (or other debt obligation) under a different set of terms. The main goal of refinancing is to usually obtain a new loan with terms that are more favorable to the borrower. Some of the reasons for borrowers wanting to mortgage refinance include:
- Reducing monthly payment amount
- Reducing interest rate
- Switch from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage (or vice versa)
- Receive cash to use for other purposes
- To consolidate two mortgages, or even other types of debt, into one loan
Reduce Monthly Payment
One of the top reasons for refinancing is for borrowers to reduce their monthly payment. This is normally done by extending the term of your mortgage. For example, if you have 15 years remaining on your current 30-year mortgage, you could refinance your current mortgage into a new 30-year mortgage. In essence, this will mean that the total payment you would be making for the remaining 15 years would now be spread out over a new 30 year period. So by paying the same amount over a longer period of time, this means that you will have lower monthly payments. However, this also means that you will be paying interest over a longer period of time, thus meaning a higher interest expense over the life of the loan. Depending on the interest rates involve, this could be a significant increase in the amount you will end up paying as opposed to if you would have stayed with your original 15-year mortgage.
Reducing interest rate
One of the other top reasons for refinancing is to reduce your interest rate. Most people understand that interest rates rise and fall on a regular basis depending on the state of the economy. At the time of writing this blog post, interest rates are near or at historic lows. Many people who have never refinanced before are probably being enticed to do a mortgage refinance with today’s low rates. While a lower interest rate is normally a good thing, make sure you calculate the closing costs into your numbers. If you don’t plan on staying in your home for at least another 4 or 5 years, the closing costs may not be worth the money you will save with the lower interest rate. Also, if the terms of your mortgage refinance include extending your mortgage a significant amount of time, your overall costs may be higher for the life of the loan, as discussed above.
Switch from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage (or vice versa)
Normally most homeowners mortgage refinance from an ARM to a fixed-rate mortgage. Since ARMs usually have lower interest rates than your typical 30-year fixed rate, homeowners will go with the lower ARM with the intention of refinancing into the more stable fixed rate at the end of the initial rate period. However, some homeowners have done a mortgage refinance from a fixed-rate mortgage to an ARM as part of their financial strategy. This is not recommended unless you fully understand the implications of what this may mean and is a strategy usually reserved for savvy real estate investors.
Receive cash to use for other purposes
One option of refinancing is to take out a new mortgage that is greater than the amount of your current mortgage. This scenario is typically known as cash-out refinancing and the difference between the new mortgage and the old mortgage is then given to you as cash. The advantage to this type of refinancing is that you can use the cash to pay off credit cards or other types of debt. Since mortgages normally have a lower interest rate than most credit cards, your overall interest rate can be greatly reduced. However, undisciplined borrowers run the risk of growing the balance on the credit cards again and then being stuck with more overall debt. Also, you will be converting unsecured debt into secured debt. With the unsecured credit card debt, the worst case scenario is that creditors ding your credit report and lower your credit score. By converting this debt over to a mortgage, you can run the risk of losing your home to foreclosure if your debt obligations are not met.
Consolidating Debt
Some people will choose to do a mortgage refinance to consolidate debt into one loan. Motivations for doing this can include simply not wanting to have to manage more than one payment or consolidating multiple higher interest debt into one lower interest mortgage. Again, if you are planning a mortgage refinance to consolidate debt to save money, make sure you do an analysis to confirm that you will actually be saving more than the mortgage refinance will be costing you.
Can I mortgage refinance for free?
I am sure that some of you out there have seen advertisements from companies offering free refinancing. They entice you into using their services by saying that there are no closing costs if you go through one of their programs. This reminds me of the saying, “if it sounds too good to be true, it probably is.” Even if they are not charging you what they consider to be closing costs, most (if not all) of these companies will be collecting money from you by either charging you higher interest rates or by increasing the amount of your principal. If anyone is considering using one of these companies, please make sure you read the fine print and that you understand all of the numbers that will be associated with the mortgage refinance. A short story about this topic was covered by ABC news not too long ago.