Refinancing Your Mortgage

In this topic, you'll learn:

• Common reasons to refinance.
• Costs associated with refinancing.
• How a home equity loan or credit line may impact refinancing.

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Home ownership is a financial milestone for many Americans, but few could afford it without borrowing. And the cost of borrowing can be significant – it’s not uncommon for families to spend 20% or more of their income on mortgage payments. In addition, the interest charged over a typical 30 year mortgage can approach or even exceed the cost of the home itself.

If you own a home, mortgage refinancing may play an important role in helping you achieve your financial goals. And since your income, home value, credit rating, and prevailing interest rates are all subject to change, a mortgage that made sense years ago may make less sense today.

When a mortgage is refinanced, the original mortgage (also known as a first mortgage) is repaid with a new one. The new mortgage typically offers a lower interest rate or a modified repayment term that better fits the unique needs of the homeowner. It’s even possible to tap the equity in your home through refinancing.

Why Refinance?

People refinance their mortgages for a variety of reasons, including:

• To lower their mortgage rate
• To lock in fixed rate after borrowing variable rate mortgage
• To accelerate repayment
• To reduce total interest costs
• To tap home equity through cash-out refinancing

For those who wish to lower their monthly payment, a general rule is that a decrease of at least one point is often worth exploring for a typical mortgage loan. For example, if someone borrowed a hypothetical $200,000 mortgage with a 30-year term at 5% three years ago, refinancing with another 30-year mortgage at 4% would save nearly $150 per month and approximately $20,000 in interest overall. The bigger the mortgage, the bigger the savings with a lower rate (even if less than a one point difference).

But what if interest rates aren’t decreasing? Interest rates rise and fall based on the overall economy. When rates are increasing, some homeowners may still find refinancing attractive in very specific situations. For example, those with a variable rate mortgage may prefer refinancing with a predictable, fixed-rate attractive to protect against potentially higher rates in the future. So even though there may be no immediate savings, protection against a potentially unaffordable mortgage payment can be important for some.

For other homeowners, accelerating repayment may be a goal. While not the only way to pay off your home more quickly, refinancing with a shorter loan term (for example, refinancing a 30 year mortgage with a 15 year mortgage) may result in faster repayment and lower overall cost, even though the monthly payment may be higher.

Again, whether or not refinancing is the right move depends on the financial situation and unique goals of each homeowner.

Running the Numbers

Calculating the overall benefits of mortgage refinancing can sometimes be complex – refinance term, monthly payment, total interest cost, how long the original mortgage has been paid, closing costs, and even tax considerations are all part of the big picture.

For example, it may be possible to refinance for a lower payment, but if a mortgage has already been paid for a decade and is refinanced with a new mortgage of the same loan term, a multi-point different in rates would be required to lower the overall cost. So while the monthly payment would be lower, the interest already paid on the original mortgage is still part of the overall cost (not to mention additional years of mortgage payments).

On the other hand, freeing up more cash each month could be a priority for some, even if the overall cost is higher. It all depends on the specific needs of each homeowner and sometimes the right answer isn’t the same for everyone.

One way to get an approximate estimate of monthly payment and total cost differences when refinancing is to use our mortgage calculator. Here’s how to do it:

• Use the sliders to enter the original cost of your home, down payment, interest rate and loan term.
• Scroll down to the bar graph at the bottom of the page.
• Hover your cursor over the bar that represents the current year of repayment.
• Write down the figures for total interest and total principal paid.

Next you’ll calculate the refinanced mortgage. Use the Home Price slider to subtract the principal figure you wrote down earlier. Don’t worry about the Down Payment value for this step, just make sure the mortgage figure on the upper right reflects the original mortgage minus the principal you’ve already repaid. This figure is the amount of your refinance loan.

From there, you can run different interest rate and repayment term scenarios to see how they affect both monthly payment and overall interest cost. And when thinking about overall cost, don’t forget to add the total interest cost you wrote down earlier to the total interest cost figure – together, both figures help you estimate total interest paid.

Remember, any figures generated by the calculator are just a rough estimate and don’t include tax implications, costs that may have been associated with your original mortgage, or costs that may be associated with refinancing.

Purchasing Discount Points When Refinancing

Depending on your lender, you may be offered the opportunity to purchase discount points when refinancing. One point is equal to one percent of the loan value – on a $200,000 mortgage, one point would cost $2,000. Each point purchased has the effect of reducing the mortgage’s interest rate by around 0.25%. So points can reduce both monthly payments and overall cost, but you’ll need to run the numbers for your specific situation to determine exact savings.

Money spent on discount points may also be tax deductible, but whether or not it’s the best use of extra cash depends on your priorities. And remember, in order to profit from the purchase of points, you’ll need to stay in the home long enough for the interest savings to pay off the original cost.

The Impact of Closing Costs

If you’re considering refinancing your mortgage, you’re probably already familiar with closing costs. These costs include legal, property assessment, and other fees associated with taking out a new mortgage. Closing costs are often between 2% and 5% of the loan amount, but they can vary significantly based on your lender, location, and other factors.

Many borrowers choose to wrap closing costs into the new mortgage, increasing the amount borrowed to avoid out-of-pocket costs. Others simply pay in cash at closing. Either way, these costs do affect the potential for overall savings when refinancing.

When considering closing costs, the big question is how long it takes to recoup the cost with the new mortgage. For example, if closing costs are $4,000 and you’ll save $100 per month by refinancing, it would take over three years to recoup the cost. If closing costs are $8,000, a $100 per month savings would take over six years to recoup the cost.

Of course, mortgage savings can be measured in ways other than monthly payment – refinancing for a shorter term may increase the monthly payment, for example, but decrease total interest cost. Either way, if the math works out closing costs may not be a big deal – if you plan to stay in your home for a while. Remember, selling your home before the closing costs are recovered means you’ll lose that money.

Special Considerations

Here are a few other points to keep in mind that may or may not apply to your situation.

Existing Home Equity Loans or Lines of Credit

If you already have a home equity loan or line of credit, refinancing your mortgage can be more complicated. In general, unless you plan to pay off a home equity loan or line of credit prior to refinancing (or through a cash-out refinancing), the lender of your secondary home loan must approve the refinancing of your mortgage. This process is called resubordination and it can add additional time and cost to the refinance process.

If this situation applies to you, your mortgage refinancing lender will be able to offer more information about the process.

Refinancing When Home Values Decline

If the market value of your home is less than the price you paid, mortgage refinancing is still a possibility. Of course, you can’t refinance your mortgage for less than its current balance, but your home equity does play a role (the value of your home minus the mortgage balance).

For example, even if your home equity was once over 20% and you no longer pay private mortgage insurance (PMI), many lenders want your current home equity to be at least 20%. In that case, refinancing may be difficult. And if refinancing with less than 20% equity is possible, you may be required to pay a monthly PMI premium – which would impact any potential savings until the 20% threshold is reached.

The Takeaway

While refinancing your mortgage can offer significant advantages, calculating the benefits for your unique situation may be complex. The advice of a trusted professional can be invaluable in helping you make decisions that are tailored to your financial goals.