Whenever interest rates decrease, as they have by nearly one percentover the past sixty days leading into the Fall of 1997, homeowners wonderwhether or not they should refinance their existing home mortgage. Homeownersmay benefit from analyzing their current mortgage to determine if a changewould improve their financial position at this time.
Refinancing is not beneficial for homeowners who assumed a 30 year fixedrate mortgage at record lows of 7% or below back in 1993 and plan to stayin their home for a long period of time. However, if a homeowner fits intoone of the categories listed below, they will most likely find that refinancingtheir mortgage can save them thousands of dollars over the term of the loan.
The old rule of thumb for refinancing stated that in order to be worthwhile, the new interest rate must be at least 2% lower than the old interestrate. With changes in the market over the past five years, the old rulesof refinancing are now defunct.
Today, as little as a 1/2% interest rate decrease through refinancingcan save thousands of dollars if executed properly and in accordance withspecific financing needs. A variety of loan terms, no-point rate optionsand lower closing cost loans have greatly decreased the rate differenceneeded to make refinancing profitable.
While many consumers spend substantial amounts of time trying to maketheir savings and investments earn more for them, few consumers really takethe time to see how much they can decrease their debt payments. Since amortgage is usually the largest debt a consumer has, it pays to concentratemost on reducing that payment first.
Many consumers are discouraged from even considering a refinance dueto old myths. One myth is that one can not refinance right after purchasinga home. As long as the loan does not have a prepayment penalty, one canrefinance a loan at any time. So if a homeowner is stuck with a high interestrate loan of 8.5% or higher right now, he or she can decrease their rateimmediately through a refinance.
Reasons to Refinance a Mortgage
There are five major reasons to consider refinancing an existing mortgage:
1) Decrease monthly payments from a higher fixed rate to a lower fixedrate. This is the simplest type of refinance. If the rate is 8.5% now anda homeowner switches to a 7.5% rate, he or she will save 1% on the mortgageless the costs of refinancing. On a $200,000 mortgage, for example, thesavings will be over $50,000 over 30 years by reducing the interest rateby just 1%. That return is better than any mutual fund or stock market investment.
2) Maximize short term cash flow with lower payments or a longer term.Many homeowners find that cash flow is tight after moving into a new home.Something always needs to be fixed or replaced. If a homeowner needs extracash every month right away, switching to an adjustable rate program wherethe rate is fixed for the next three to ten years could give the breathingroom needed for a definite period of time. Similarly, for those who arein a 15 or 20 year term loan, switching to a 30 year term can also increasemonthly cash flow.
3) Switch to a fixed rate program to eliminate payment changes of adjustablerate mortgages (ARMs). Homeowners with one year ARMs that started at 6%or lower in will see their rates rise to about 8.25% this year. Using programsthat hold rates steady for three, five or seven years, one can refinancenow into a rate between 6.50% and 7.50%. Not only does that bring immediatesavings, but it protects against an even higher rise in their one year adjustablerate loan next year.
4) Withdraw funds from the equity in a home. If a homeowner needs cashfor home improvements, college education or to consolidate debts, he orshe may be able to refinance 75% to 80% of the current value of the homeif it has been owned for one year or more.
Pushing for Shorter Loan Terms
Probably the best incentive to refinance is found by refinancing intoa shorter term loan while keeping the loan payment relatively stable. Aborrower who has a $200,000 loan with a 30 year fixed rate at 8.25% pays$1,503 per month and will repay $540,943 including the principal borrowed.A borrower who has had this loan for five years would still have $450,600in payments to go. Refinancing into another 30 year fixed rate at 7.25%will lower the monthly payment to $1,365 (saving $138 per month), but theoriginal 30 year term will extend to 35 years (five years with the originalfirst mortgage and thirty with the new refinance loan) and the borrowerwill actually end up repaying $492,000 under just the new loan. The bottomline is that under this scenario a borrower saves $138 per month, but endsup about the same amount after 30 years as if no refinance had taken place.
A smarter long term strategy would be to take out a 20 year loan withpayments of $1,580 per month, because even though it will be $77 per monthmore than the old payment at 8.25%, the borrower will only have to make$379,000 in payments over 20 years. Thus, by paying an additional $77 permonth which is $18,480 over 20 years, and by lowering the interest rateto 7.25%, the borrower can save over $110,000 in total mortgage payments.
Strategies for the Sophisticated Borrower
Borrowers who currently have mortgage insurance on their loan becausethey purchased with less than a 20% down payment may be able to eliminatemortgage insurance by refinancing. One of the most popular new loan productstoday is the “80-10-10” program. Under this loan plan, (see articleon page 13), borrowers obtain a first mortgage for 80% of the value of theirhome and a second mortgage for 10% of the home’s appraised value. By splittingthe loan into two separate loans, the first mortgage will not require mortgageinsurance and the borrower can save the monthly premium payment.
Another benefit of the 80-10-10 program is that if a borrower has a jumboloan (defined as a loan greater than $214,600 for a single family home)but can decrease the first mortgage loan to below $214,600 with the 80-10-10program, then the borrower can obtain lower rates that are available withconventional mortgage loans below $214,600.
Refinancing Costs Lower Than Ever
The costs of refinancing have decreased greatly in the past several years.With no-point loan options, for example, borrowers can save thousands ofdollars up front (one point is equal to one percent of the loan amount).Also, closing costs can usually be included in the new mortgage loan amountso that no cash is required to execute a refinance. Deciding whether torefinance usually involves totaling the costs of refinancing and subtractingthose expenses from the total savings expected. It is also important todetermine how many months it will take to pay back the costs of refinancingfrom the savings that will accrue.
For example, if a refinance is reducing the rate on a $150,000 loan from8% to 7% with no points, the savings will be approximately $107 per monthand closing costs will be about $1,600. If the home is kept for at leastthe next five years, the borrower will save $4,820 over that time period(60 months x $107 less $1,600 for costs). Over ten years the savings wouldbe $11,240, and over 30 years would reach $36,920 It will take 15 monthsto break even on the transaction, so as long as the homeowner does not movebefore then they will come out ahead.
For those borrowers looking for short-term savings, the no-points/noclosing costs option may be for them. For a slight premium on the interestrate, one can obtain a loan with no points and no closing costs. For example,when a borrower has a current rate of 9% rate and 0-point rates are at 8%,he or she can have all closing costs paid for if by taking an interest rateof 8.25%. While this plan reduces total savings over the long-term, onecan obtain immediate savings with no cash outlays.
Would Refinancing Be Worthwhile?
There are five main factors to analyze when determining the costs andbenefits of refinancing: 1) What will be the difference between the oldrate and the new rate? 2) What are the total costs associated with the refinancetransaction? 3) How closely is the loan term matched with the expected holdingperiod of the loan? 4) How comfortable are is the homeowner with possiblepayment changes over the life of the mortgage loan? and 5) Is a first mortgagestructure sufficient or should a home equity line be added?
The savings that can be obtained from refinancing depend directly onthe answers to the above five questions. It is best to answer these questionswith the help of an experienced mortgage professional.
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