Refinancing Your Mortgage

A mortgage refinance—or “refi”—sounds like a redo of your current mortgage. It’s actually a new loan that pays off your current mortgage and starts you over with new rates, new terms and/or a new principal balance. People refi for two main reasons:

• To create a lower monthly payment, on a short-term or long-term basis
• To convert equity in your property to cash. This occurs when the refi amount exceeds the previous mortgage amount.

A refi can offer certain benefits and advantages. That does not make it the right move for every property owner in every scenario. It’s important to know when it makes sense. It’s also important to know that a refi always comes with costs—the costs of the loan itself and the terms and obligations that come with the new debt.

When a Refi Can Make Sense

Lower Interest Rate

You may be able to obtain a new loan at a lower interest rate than your current mortgage. This can be due to several reasons:

• You took out your current mortgage when interest rates were higher
• Your current loan is an adjustable rate mortgage (ARM) that has adjusted upward
• Your credit profile was worse when you took out your loan, only allowing you to qualify for a higher interest rate given to riskier borrowers

Many people are refinancing from ARMs to fixed-rate mortgages to lock in a stable rate for the duration of the loan. In the lead-up to the current housing and credit crisis, many people took out ARMs because of the low initial rate. Certain loans may be available today with lower introductory rates. While the immediate cash flow benefits of such loans are real, they come at a price—namely, the day when the loans adjust to potentially higher interest rates. Also remember that the true cost of a loan is not the monthly payment; it is the total amount of interest due over the life of the loan. A lower monthly figure may come with extended terms, which in turn may require you to pay more total interest dollars overall.

Consolidating Home Loans

If you have taken out a second mortgage (sometimes a type of loan known as a HELOC, or home equity line of credit) in addition to your primary mortgage, you may want to pay off both with a new, single mortgage whose monthly payment will be less than your combined payments on your primary and second mortgages.

Cash In-Hand

When you refi for an amount greater than your current mortgage, the difference becomes cash in-hand. This money can (and should) be applied productively.

Paying Off More Expensive Debt

If you have a large amount of debt at high interest rates, it may make sense to pay off that debt with money derived from your home (see “Cash In-Hand” above) if the interest rate on your refi is lower than the interest rate on the debt you want to eliminate. An additional potential benefit: mortgage interest payments can be tax-deductible while interest payments on many other types of debt are not.

Stable Interest Rate

As mentioned previously, many homeowners are refinancing ARMs (adjustable rate mortgages) with fixed-rate mortgages. This kind of refi can provide peace of mind that your monthly payment will never change.

When a Refi May Not Make Sense

Insufficient Difference Between Old and New Interest Rates.

Refis come with certain costs and conditions. True savings are hard to achieve unless the new mortgage has a rate that is at least 2% less than the previous mortgage.

Low Equity

The less equity in your home, the greater chance you have of going “underwater,” when the amount of your mortgage exceeds the market value of your home. This situation has befallen millions of homeowners in the recent housing crisis. If your equity is already low (approaching 10%), pulling money out of your home with a refi increases your odds of going underwater should home prices drop in your area.

Long Period of Payment on Current Mortgage

When you refi, you start over on your payment schedule. It may not be worthwhile to go back to “square one” when you have already been paying for a long period of time on your current mortgage, especially if you are only a few years from paying it off.

Preparing for a Refi

To have the best chance of being approved for a refi at the best possible rates, do the following:

No Late Payments for 12 Months

Make sure you have no late payments on your current mortgage for the past 12 months. If a payment is late, make that payment, then begin a disciplined one-year period of making all payments on time.

Strong Credit Report

Run your credit report and check for any negatives or inaccuracies. Work with a credit report professional (like your loan officer) to remedy any “black marks.” Your credit score will improve as problems are addressed and good credit habits are maintained—timely payments, no maxed out accounts, not arbitrarily closing accounts. The better your credit score, the more likely you will be approved for a refi at the best possible rates.