To determine if refinancing is right for you, you should think about your reasons for refinancing.
Refinancing your current loan may make sense for one or more of these reasons:
* If you want a lower interest rate and monthly payment
* If you want a fixed monthly payment rather than one that can increase as interest rates rise
* If you want to use some of your home equity to pay for home improvements, education costs, or other needs
* If you want to build equity in your home at a faster rate
* If your credit rating has improved since you obtained your current mortgage loan, and you want to benefit from more favorable loan terms
The better you understand your motivations, the easier it is to work with a mortgage lender or mortgage broker to discuss your refinance options and arrange the right refinance transaction for you.
Lower Your Interest Rate
The most common reason for refinancing is to lower the mortgage interest rate and the monthly payment. A lower interest rate will result in a lower monthly payment as long as you don't significantly increase the principal balance of your mortgage loan by "cashing out" some of the equity or value you have built up in your home.
When interest rates are low, refinancing out of a higher-rate loan may make good business sense. For example, suppose you decide to refinance from a $100,000 30-year fixed-rate mortgage at a 7.5% interest rate to the same mortgage amount and term at a 6% rate for a cost of $2,000. Your monthly payment of principal and interest for the new loan would be $599.55 versus a monthly payment of $699.21 for the old loan. As a result, you would save roughly $100 per month on the principal and interest portion of your mortgage payment.
When considering a refinance to obtain a lower rate, it is important to know how long it takes to recoup the cost of the refinance transaction. In the previous example, you would break even on your $2,000 cost to refinance after 1 year and 8 months of monthly payments.
If you plan to sell your home in the very near future, refinancing might not be your best option. However, if you plan to remain in your home well beyond the time it would take to recoup your refinance costs, you can save a considerable amount on interest payments over the life of your loan.
Change Loan Products
You may want to use a refinance transaction to switch from one type of loan product to another, such as from an adjustable-rate mortgage (ARM) loan to a fixed-rate loan. This may make sense if interest rates have fallen since you took out your ARM and you now want the assurance that your interest rate will remain the same for the life of your loan.
Your mortgage payments with an ARM adjust with changes in market rates: when interest rates change, your monthly payments change at the next rate adjustment period. The interest rate on an ARM will adjust periodically (for example, annually, every six months, or monthly) after an initial fixed period. But with a fixed-rate mortgage, your interest rate stays the same for the entire term of your loan.
You may have selected an ARM when mortgage interest rates were higher because it offered a lower initial interest rate and monthly payment than a fixed-rate loan. When interest rates fall, refinancing to a fixed-rate loan can guarantee a lower interest rate for the life of the loan.
Here is another scenario. You might want to change from one type of ARM to another to get a better combination of rate and term. For example, you may want to switch from a one-year ARM (in which the rate adjusts annually) to a 5/1 ARM (in which the new rate remains fixed for the first five years and then adjusts annually).
Before you decide to refinance from one type of ARM to another, you should compare the financial index, margin, and any rate caps on your existing ARM with current market rates. It is important to understand how often your mortgage will adjust and how much your payment can change with each adjustment and over the life of the loan. Also, be sure to ask your lender or mortgage broker whether any conversion terms apply or if there are costs to convert to another type of mortgage.
Tap Home Equity
Equity is the difference between what a property is worth and the amount still owed on the mortgage. You build equity in your home with each monthly mortgage payment. A portion of your payment is used to pay principal — helping you build equity by reducing the loan balance — and the rest is used to pay interest, taxes, and insurance. You may also have additional equity built up in your home if it has appreciated in value since you took out your loan.
You can use a refinance transaction to tap into the equity you've built in your home and borrow additional funds, for example, to pay for home improvements, educational expenses, or a major purchase. This is often referred to as a "cash-out" refinance.
Build Equity Faster
You may want to refinance in order to build equity more quickly than you can with your current mortgage. This may be desirable, for example, if you are nearing or planning for your retirement and you want to pay off your loan more quickly.
By refinancing from a 30-year mortgage to one with a shorter term — such as a 10-, 15-, or 20-year mortgage — you increase the amount of your monthly payment that goes toward reducing the principal balance of your loan. This approach typically makes sense for homeowners who can afford an increase in their monthly mortgage payment because generally the shorter the loan term, the higher the monthly payment.
Get More Favorable Loan Terms
You may now be in a high interest rate loan because that was the only type of loan offered to you due to problems with your past credit history. Since you took out your loan, you may have improved your credit rating. If so, you may be able to refinance to obtain a loan with more favorable terms and a lower interest rate.
Refinancing to a lower rate loan may save you a significant amount in interest costs not only each month, but also over the life of the loan.
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