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 agarwal.sudhir@gmail.com.
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