Mortgage Refinancing

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Mortgage Refinancing

With interest rates still lower than historical averages, for many, it makes sense to lock in a new mortgage at a lower rate (perhaps even for a longer term than your current mortgage). This can be accomplished through refinancing. Essentially, refinancing is paying off an existing home mortgage with a new one. The new mortgage with lower interest rates will eventually save you money. Notice the word "eventually" was used.

The costs associated with refinancing may mean that it could take some time before you begin to save money. A simple formula can be used to estimate how long it can take before you begin to reap the benefits of refinancing.

Refinance Costs divided by Monthly Savings = (the approximate number of) Months to Recover Costs

Here is an example:

Let's say you have a 30 year $150,000 mortgage with a fixed interest rate of 8%, which carries a montly payment of $1,100. Through refinancing, you obtain a new 30 year mortgage at 6% with monthly payments of less than $900. The cost of closing the new mortgage is $5,000.

Now, let's use our formula:

Refinance Cost: $5,000
Monthly Savings: $200 per month or $2,400 a year (approximately)
$5000 divided by $200 = 25 months or just over 2 years to recover costs

The example above was simplified to show how the refinancing costs recovery formula works. Cost recovery time will be much different if closing costs are payed out of pocket compared to the time it will take if closing costs are added to the principal of the new mortgage.

Other reasons to refinance

There are a number of other reasons to refinance a home mortgage.

build equity faster

select a different type of loan

take advantage of an improved credit rating

Build equity faster
Let's say it is now possible for you to pay higher monthly payments. Refinancing your mortgage with a shorter term will allow you to build up equity in your home at a faster pace.

Select a different type of loan
If interest rates are moving higher, you might consider switching from an adjustable rate mortgage (ARM) to a fixed rate mortgage, in order to take advantage of the current rates and gain monthly payment stability. When interest rates are trending downward, perhaps switching from a fixed rate mortgage to an ARM will be cost saving move.

Take advantage of an improved credit rating
Improvements in your credit rating may mean you are now eligible to receive interest rate offers made only to the most creditworthy borrowers. Refinancing to receive a new mortgage with lower rates may be right for you.

How much is enough equity?

Many lenders look for a loan-to-value (LTV) ratio of 80% or less (note: Fannie Mae recommends 90% or less). For example, a home with an appraised value of $100,000 that carries a mortgage balance of $80,000 (remaining loan amount), would have a 80% loan-to-value ratio. The value would be $20,000, or 20% equity in the home.

What are the requirements and associated costs?

Expect that the lender will require employment and income verification, information regarding debts and assets, account balances and numbers for savings, checking, and other financial accounts, a title search, a copy of the site survey, and, at the very least, an exterior appraisal.

It will also be required that you provide information about your present mortgage, such as current monthly payment, remaining mortgage balance, status of property tax and insurance payments, and the lender's contact information, unless, of course, you are refinancing through the same lender.

Many of the fees you payed during your original mortgage closing will be charged when you refinance. These might include a loan origination fee, discount points, title search and title insurance fees, prepayment penalties, an application fee, appraisal costs, and possibly legal service fees. (See the mortgage loan basics section for additional information.)

Quite a few lenders offer a "no cost" refinance in which the fees and other costs are added to the new mortgage. This means that there may be very little or no out of pocket expense at closing. However, the lender could increase the rate of interest or add the cost to the principal amount you borrow, which would increase your monthly payment.

If you choose to pay points, usually they are tax deductible during the life of the loan, unlike the total deduction you may take when you first buy the home. For example, if you refinance with a 30 year mortgage and pay $3,000 in points, you likely will be required to deduct 1/30 of $3,000 or $100 each year you own the home, rather than deducting all $3,000 in the year you refinance.

Updated: Nov 2005