Is Refinancing Suitable for You?
People refinance to get rid of mortgage insurance (PMI); shorten the length of the loan; get lower interest rates; borrow money from home equity for renovation, investment, or debt consolidation; and convert a loan from ARM to fixed rate or vice versa.
Refinancing can provide benefits, but there are some pitfalls as well. And because refinancing can cost 3 to 6 percent of the loan’s principal and requires (not unlike original mortgages) an appraisal, title search, and application fees, it’s important for a homeowner to determine whether his or her reason for refinancing offers a true benefit.
Removing the PMI
This may not be common in a stagnant market, but we have seen this commonly in the growth market. Most people buy a house by contributing 5 to 10 percent. Property prices in the last five years (2012-2017) have grown significantly, so many people have more than 20 percent equity in their house (as per current appraised value) but are still paying PMI. Eliminating the PMI with a refinance can be a significant savings over the period of the loan.
Securing a lower interest rate
One of the best reasons to refinance is to lower the interest rate on your existing loan. According to the historical rule of thumb, it was worth the money to refinance if you could reduce your interest rate by at least 2 percent. Today, many lenders say 1 percent savings is enough of an incentive to refinance. Your monthly payment could be lower: for example, a 30-year fixed-rate mortgage with an interest rate of 4.50 percent on a $500,000 home has a principal and interest payment of $2,937.57. That same loan at 4.00 percent reduces your payment to $2840.40. So you save $100 per month or $1,200 in a year. This could be a significant saving and could be used to pay the insurance cost on the house. Reducing your interest rate also increases the rate at which you build equity in your home.
Changing the loan’s term
Another reason for refinancing is to change the payment term. For example, the mortgage for a house can be constant over the period, although income might keep rising; in the later stage of the life of this loan, people could afford higher payments and want to convert their loan from 30 years to 15 years. Note that many people do it the other way around also so that they can use the extra cash for some other purpose.
Converting between mortgages
Historically, ARMs (Adjustable Rate Mortgages) have been lower than fixed-rate mortgages. While ARMs generally start out offering lower rates, adjustments often result in rate increases that are higher than the rate available through a fixed-rate mortgage. This generally occurs in an increasing rate market. When this occurs, converting to a fixed-rate mortgage results in a lower interest rate and eliminates concern over future interest rate hikes. Alternatively, many people convert from fixed-rate loan to an ARM, especially in a falling interest rate environment. If rates continue to fall, the periodic adjustments on an ARM result in decreasing rates and smaller monthly mortgage payments, eliminating the need to refinance every time rates drop.
Noncitizen/nonpermanent residents looking for a jumbo loan find very few banks helping them, and when available, the rates can be high, so these clients might start with an ARM because of the interest rate difference. Looking at all options, we suggested a 5/1 ARM to such a client.
Debt consolidation through home equity
Though this is another major reason people specify for refinancing, it should be avoided if possible. Homeowners often access the equity in their homes to cover expenses, such as college, buying a new car, or home remodeling. These homeowners may justify such refinancing by pointing out that remodeling adds value to the home or that the interest rate on the mortgage loan is less than the rate on money borrowed from another source. Another justification is that the interest on mortgages is tax deductible. While these arguments may be true, increasing the number of years that you owe on your mortgage is rarely a smart financial decision, nor is spending a dollar on interest to get a 30-cent tax deduction.
Many homeowners refinance to consolidate debt. At face value, replacing high-interest debt with a low-interest mortgage is a good idea. Unfortunately, refinancing does not bring with it an automatic dose of financial prudence. Take this step only if you are convinced you’ll be able to resist the temptation to spend once the refinancing gets you out from under debt.
The bottom line
Refinancing can be a great financial move if it reduces your mortgage payment, shortens the term of your loan, or helps you build equity more quickly. When used carefully, it can also be a valuable tool in getting debt under control. Before you refinance, take a careful look at your financial situation and ask yourself, ‘How long do I plan to continue living in the house? And how much money will I save by refinancing?’
It also pays to remember that a savvy homeowner is always looking for ways to reduce debt, build equity, save money, and eliminate that mortgage payment. Taking cash out of your equity when you refinance doesn’t help you achieve any of those goals.
Sudhir Agarwal, a mortgage specialist, is the founder and CEO of Churmo.com, an AI-based platform that connects real estate professionals with buyers and sellers. For a free assessment of your current situation and to understand if you should refinance or not, call him @ 770-289-0370 or email email@example.com.
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