By Catey Hill, courtesy of Zillow
The super-low interest rates mortgage companies are now offering make refinancing tempting. Who wouldn’t want a rate just around 3 percent? Refinancing can help build equity in a home faster, shorten the loan term, lower monthly mortgage payments, lessen the amount of interest owed and more. But refinancing isn’t always the right option and can be costlier than sticking with a current, higher-rate loan.
Borrowers can figure out whether refinancing is right for them by looking at the reason(s) they’re refinancing and whether these are viable ways to reach their goal.
Refinancing to Take Advantage of Lower Interest Rates
The primary reason homeowners choose to refinance is so they can reduce the cost of their mortgages, paying less to the bank in interest and lowering their monthly payments. Consider a homeowner with a 30-year, $200,000 mortgage at a 5 percent interest rate with a monthly payment costing about $1,074. They will pay more than $186,000 in interest over the life of the loan. Compare this to the homeowner who pays only 3 percent interest rate on the same mortgage. They will pay just over $103,000 in interest and have an $844 monthly payment.
However, the choice of whether to refinance is not as simple as just comparing interest rates. Homeowners also have to think about how long they’ll live in the home and the closing costs. Closing costs average about $3,700, and borrowers often pay them upfront, so they must weigh these costs into their decision. If they plan to move in the next few years, they likely won’t recoup these closing costs even though they’re paying less in interest and have smaller monthly payments. Individual homeowners can calculate whether refinancing makes financial sense for them based on how many years they plan to live in their homes. In general, refinancing with upfront closing costs makes the most sense for people who plan to stay in their home for about five years or more, though the exact time frame varies from person to person depending on how much lower the new interest rate is and the total cost of closing the loan.
That said, even homeowners who plan to sell their homes soon can benefit from refinancing, as many companies offer “no-cost refis,” which are refinance loans where borrowers don’t pay upfront closing costs. This doesn’t mean that these loans are “free,” however: Usually the borrower pays a higher interest rate in exchange for not having to pay upfront closing costs or the lender rolls the amount of the closing costs into the total loan amount. In both cases, the borrower will likely pay more in interest over the life of the loan than with an upfront-closing-cost refinance. That however, may not matter to a borrower who plans to sell soon, as the out-of-pocket closing costs will likely be more than he or she pays in interest over the next few years.
Refinancing to Change The Loan Term
Some homeowners refinance to change the terms of their loans. One way is to shorten the term of the loan, which can save borrowers tens of thousands of dollars in interest over the life of the loan, though it often dramatically increases monthly payments. Consider: Homeowners pay roughly $66,000 in interest on a 15-year, $200,000 mortgage at 4 percent, compared with more than $143,000 in interest on a 30-year, $200,000 mortgage at 4 percent. Though, monthly payments are higher on the 15-year mortgage, roughly $1, 480 vs. $955. Homeowners must think about how higher monthly payments will impact their monthly cash flow and whether they can truly afford their lifestyle and continue to save money for other goals. Then, weigh that against how much money a refinance would save them in the long term.
On the other hand, some people refinance their loans to longer terms to lower their monthly payments. So, these homeowners may have been paying off their 30-year mortgages for the past decade having 20 more years before they outright owned their homes. After they refinanced into another 30-year mortgage, they have 30 more years before they truly own their homes – essentially a 40-year loan overall. Though their monthly payments may be lower because they are paying the loan over a longer period, they will pay more over the life of the loan in interest than if they’d opted for a shorter term and will have to wait longer before their mortgage is paid off.
Refinancing to Get Cash
Some homeowners hope to do what’s called a “cash-out refinance,” which means they take out a new mortgage for more than they now owe and take the difference in cash. The benefit of this deal is near-instant cash. But homeowners pay more in the long term than they would with a traditional mortgage, as lenders often charge higher interest rates for cash-out refis, and borrowers have to pay interest on a higher total loan amount. Borrowers must weigh their need for cash (could it be used to pay off a higher interest rate debt?) with the higher financial burden of a cash-out refi and the risk (the home is collateral on these loans).
Refinancing to Change the Loan Type
In today’s low-interest rate environment, many homeowners hope to switch their adjustable-rate mortgages (ARMs) to fixed-rate mortgages to lock in low rates. Fixed-rate mortgages give borrowers peace of mind in that they don’t have to worry about future rate hikes. On the flip side, if interest rates fall, ARMs can remain attractive, as they may offer lower rates than with a fixed-rate loan.
Bottom Line
Borrowers who decide that refinancing can help them reach their goals should get quotes from at least three lenders, looking at the interest rates, closing costs, fees, penalties and other terms for each loan.
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