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By: Bill Williams, Vice President
Does refinancing your mortgage loan make sense for you right now? In order to make that decision, you need to understand what, exactly, refinancing entails and what benefits it could offer to you as a homeowner.
Refinancing is simply trading in your old mortgage loan for a new one. The process generally involves applying for a new mortgage loan and using the proceeds to pay off your existing loan. In essence, you would follow the same paperwork process as you did when you originally financed your home. Note that the fees and other related costs associated with the refinancing are usually rolled into the new mortgage loan so you don't incur any out-of-pocket expenses.
Reasons To Refinance
There are several reasons why refinancing may make sense for you. First, you may want to lower your monthly mortgage payment. If interest rates have dropped significantly since you obtained your existing mortgage loan, you may be able to substantially reduce your monthly payments. As a general rule, for each one percent interest reduction on $100,000 borrowed for 30 years, you will ultimately save $25,000 over the life of the loan.
Second, you may have built up substantial equity in your home and want to access some of that in cash. In this case, you could refinance and borrow more than you currently owe on your existing mortgage loan. In this way, you can pay off the old mortgage loan and use the difference for such things as home improvements, education expenses, or debt consolidation.
A third reason to refinance may be to change the terms of your existing mortgage loan. For example, you may wish to replace your current adjustable-rate mortgage loan with a fixed-rate mortgage loan to add stability to your monthly expenses. You may also wish to switch from a 30-year term to a 15-year term or lower, which can save you thousands of dollars over the term of the mortgage loan and help you build up equity in your home more quickly than under a longer-term mortgage loan.
When To Refinance
The old rule-of-thumb was that the best time to refinance was when you could reduce your interest rate by 2 percent or more. That baseline may no longer be appropriate with the advent of "no-cost" refinancing options. But make sure that you understand what this term means - "no cost" simply means that you may not have to pay any out-of-pocket costs. Instead, the loan costs - and there are always costs - will be rolled into the new loan or factored into the interest rate. This is a factor you must consider when deciding whether to refinance.
The best formula to follow when deciding if refinancing makes sense for your situation is to calculate how long it will take to recoup your costs. To do this, simply weigh the monthly savings of the new mortgage against the total up-front costs (including those costs that will be rolled into the new loan). For example, if you would save $100 per month with a new mortgage loan and pay $2,000 in up-front costs, you would need to stay in the home for 20 months in order to break even. If your intention is to move sooner than that, it would not make sense to refinance the existing loan. However, if you plan to live in the house longer than 20 months, you should consider the refinancing.
Preparing For The Paperwork
Since refinancing involves getting a new loan, you should be prepared to follow the same process you undertook with your original financing. The refinancing will require essentially the same documentation, so gather your pay stubs, W-2 forms, bank statements, and a copy of your deed. If you are self-employed, you will need to provide copies of your last two years' federal income tax returns as well as a year-to-date profit and loss statement. Also be prepared to give the lender a check for the application fee, which will cover the lender's expenses in having to obtain an appraisal and a credit report.
Be aware that your credit will be checked, so you should consider doing whatever you can to improve your credit rating. You may want to pay down some credit cards and/or get rid of those you do not use, and you should pay all of your bills on time. This may help the refinancing process proceed more smoothly for you.
Selecting a Product
As with your original loan, you can generally select either a fixed-rate or adjustable-rate mortgage loan when you refinance. Most people choose a 30-year, fixed-rate mortgage loan, and for good reason. This type of loan enables you to know what the principal and interest payment will be for the entire term of the loan, and it will never change. You can also amortize your mortgage loan over a shorter period, from 5 years to 25 years, as long as you are comfortable with the payment.
Adjustable-rate mortgage loans offer a number of attractive benefits, such as lower initial interest rates than are generally available for fixed-rate mortgage loans and a wide range of adjustment periods. These adjustment periods are often available at 1-, 3-, 5-, 7-, and 10-year intervals. The shortest adjustment periods usually have the lowest rates. While adjustable rate mortgage loans will almost always offer lower rates than fixed-rate loans, you must be prepared for the adjustments.
Choosing a Lender
Once you have decided to refinance your mortgage loan, you must choose a lender. You may want to begin by contacting your current mortgage company, which may offer you an attractive package in order to keep your loan. If you decide to shop around, you should contact local banks, credit unions, and mortgage companies, and you may also want to search the Internet. There are few limits to the amount of information available.
Everyone wants to get the lowest rate available; however, it is not always wise to choose the lender that quotes rates that seem lower than the overall market. Such a lender may not be able to deliver on its promises. The most important thing to do is to find a reputable lender that will provide you with quick and efficient service while offering a competitive interest rate. Then you can sit back and focus your attention on what to do with all of the money you will be saving.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.