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When is it the Right Time to Refinance
In order to decide if you should refinance your current mortgage several things need to be addressed. Your mortgage, being the largest debt you have, is also your cheapest avenue to capital. You are giving the lender a first lien position on your home, giving their loan the highest level of security they can get. Since the cost of borrowing money is directly related to the risk incurred by the lender, you are entitled to the lowest possible rate of interest. As a bonus, the interest, under most circumstances, is tax deductible. This makes the mortgage a powerful tool for personal financial planning.
Let’s first identify all the things that you will need to consider.
The details of your current mortgage or mortgages: The current rate, remaining term and outstanding balance on your mortgage is the first thing you want to look for. Collect the same details on any second mortgage or equity line of credit you may have. You should also look to see if you are currently paying for mortgage insurance on your present mortgage. This is another potential area for savings.
What is the current rate environment: In this preliminary analysis you don’t need to know the absolute best rate that’s available, just approximately where the rates are. Forget the old adage that the rate needs to drop 2% before it makes sense to refinance. Most often, a much smaller drop in rate is cost effective and in some cases 2% is not nearly enough. As we go through this analysis you will see why.
What is it going to cost to do the refinance: We will need to factor in the closing cost as well as where that cost is coming from. Do we want to pay the cost with cash on hand? Do we want to finance the closing costs into the mortgage? Here again, it is too soon to need an accurate figure, so we will use a factor of 3% of the mortgage amount for a rough approximation. See Closing Costs for a more accurate itemization.
What is my home realistically worth: At this point in the analysis, a conservative estimate based on what you’ve seen sold or advertised in the local newspapers, is all we need. The actual refinancing process will begin with an appraiser being hired to do a market analysis of your home. This is when we will have an exact value and it is this report that the lender will use in deciding what the maximum mortgage they will permit on your home.
What is your current income: You need to take an objective look at your current income and any foreseeable changes for the near term. Are there currently 2 incomes coming into the household? Are one of you going to stop work to raise a family, take a sabbatical, etc? Or, is the reverse happening? Is overtime in danger of stopping?
What are your current expenses: The next step is to look at what you presently have outstanding on personal loans, car loans, student loans, credit cards, etc. List the balances, interest rates and minimum payments.
What upcoming expenses are you facing: Does the house need any major repairs? Do you have a child entering college? The goal here is to see what major capital expenditures you will be facing in the near future.
Now you have enough information to determine if refinancing is in your best interest. Let’s assume, for the moment, that you have no outstanding debt, or need for additional capital and all you want to do is see what you can save in interest with a lower interest rate. We are going to take your current mortgage balance, add an estimate of the closing costs to it, use the current interest rate and calculate a new mortgage payment. By subtracting this number from your current mortgage payment (remember to use only the mortgage portion of your payment, make sure you’re not including any escrow payment you’re currently making) you will see exactly how much you are savings monthly. You can then evaluate if the savings is large enough to warrant the refinance.
Example 1:
You purchased your home in 1999 for $200,000 and you financed $160,000 @ 8 ½% for 30 years. Since you originally put down 20% there is no mortgage insurance component to deal with. Your current mortgage payment is therefore $1,230.26. The current interest rate is 6%, you’ve paid 5 years into the mortgage so your outstanding balance is $152,785.00, we will take a 3% factor for closing costs bringing us to a new principle balance of $157,400.00. Now, recalculate the monthly payment based on 6% for 25 years. Your new payment is $1,014.13 per month. This $216.13 per month savings is exactly what you saved based on the rate change. If were to do this calculation on a 30 year mortgage, the new monthly payment would be $943.69. A savings of $286.57. Although this savings is real, it can lead you to an improper conclusion. Only $216.13 of the savings is due to the drop
in interest, the remaining $70.44 in savings is due to extending the mortgage out another 5 years. It is important to always compare the same terms from your current mortgage to the new mortgage. This way you will know exactly what the monthly savings is due to the reduction in interest rate. Taking the estimated closing costs (in this case we used $4,615.00) and dividing it by the savings due to the reduction in interest rate ($216.13) we find that it will take 22 monthly payments to recoup the money used to complete the refinance transaction. If this timeframe is satisfactory to you, then going on with the refinance is the course to take. If you decide to keep the mortgage at 25 years, extent the mortgage to30 years, shorten the term, or pay the closing costs out of pocket you can be confident in knowing that you are in fact saving money.
Example 2:
You purchased your home in 1985 for $200,000 and you financed $160,000 @ 8 ½% 30 years. Your current mortgage payment is still $1,230.26. But in this case you’ve paid down your mortgage to $99,227. Using the same 3% closing cost factor we will be mortgaging $102,200 @ 6% for 10 years, giving you a mortgage payment of $1,134.63. The savings now is only $99.63 per month.
From these 2 examples we can conclude that the older the mortgage is, the larger the rate reduction needs to be. We can also conclude that the smaller the mortgage amount is, the larger the rate reduction needs to be. Another thing that you need to keep in mind is that the closing costs have certain fixed expenses. When the loan size is less than $100,000 the fixed costs represent the major portion of the expense. The 3% factor we’re working with quickly begins to lose its accuracy. To keep this estimate conservative, use a fixed closing cost factor of $3,000 for loan sizes under $100,000.
Example 3:
You purchased your home in 1999 for $200,000 and you financed $160,000 @ 8 ½% for 30 years. Your current mortgage payment is still $1,230.26. Your home has appreciated to $275,000 but you have built up $25,000 in credit card debts over the years and your son just got accepted to a private college. Your credit card debt requires a monthly payment of $750.00 and you want to help your son out paying for his higher education. Money is already tight at the end of the month. You refinance your home for $220,000 for 30 years @ 6%. Your new monthly payment is $1,319.01 per month. You increase your mortgage payment by $88.75 per month, eliminate the $750.00 in credit card bills and at the same time free up over $35,000 of equity. You have helped your monthly cash flow by over $660.00 per month in addition to being able to contribute $35,000 towards college.
The limits you need to keep in mind are:
1. You will need to keep the mortgage amount to no more than 80% of the value of the home or be prepared for higher financing costs. This issue is beyond the scope of this paper. Just keep in mind that loan-to-values greater than 80% carry a higher risk so therefore will have a higher interest rate.
2. You don’t want to take on more debt than you can handle. Lender will not commit on a mortgage if they don’t feel your income can carry the payments. But that’s only half the story. You don’t want to carry any more debt than you have to, or feel you can afford to. You’re the one making the payments, not the lender.
3. If your credit profile has changed since you closed on your first mortgage then this will impact your ability to refinance. If you were having credit problems at the time you took out the first mortgage, and corrected them, you will find you have many more options now. If you have run into financial difficulties since you financed your home, then your ability to refinance now will be restricted.
As you can see, there is more to refinancing than looking for a 2% drop in rate. Your home is your largest asset. Your mortgage is your largest expense. They may be the biggest components of your financial position, but they are not the only parts. They need to be balanced with everything else in your life so they can be used most effectively. Take the time to discuss your refinance with some one who is knowledgeable before you apply for the mortgage. It will be time well spent.
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