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Is it Time to Refinance?

By: Financial Hotline
Winter 2021 (Vol. 38, No. 4)

Q: Should I refinance?

A: That depends. Are interest rates more than 1% below your current rate? Has your credit score improved enough that you might be eligible for a lower-rate mortgage? Can you switch to a shorter term for the same monthly payment? Do you need to lower your payment to save your home?

The answers to these questions will influence your decision. But before deciding, you need to understand all that refinancing involves. Remember that, along with the potential benefits to refinancing, there are also costs.

Q: The rate is 1% lower and I will save $108 per month. Isn’t this a no brainer?

A: The interest rate on your mortgage is tied directly to how much you pay on your mortgage each month-- lower rates usually mean lower payments. For example, compare the monthly payments (for principal and interest) on a 30-year fixed-rate loan of $200,000 at 3.5% and 2.5%.

  • Monthly payment @ 3.5% $898
  • Monthly payment @ 2.5% $790

Its easy to see the difference when you first purchase your home but there are several variables to consider when you are refinancing. For example, even if the rate and payment are much lower, if you are halfway or more through your current mortgage, you may end up paying more by refinancing. In the later years of your mortgage, more of your payment applies to principal and helps build equity. By refinancing late in your mortgage, you will restart the amortization process, and most of your monthly payment will be credited to paying interest again instead of building equity.

You also have closing costs, pre-paid and out of pocket expenses when you refinance. In your case, these costs total $6938. So you will pay $6938 now to save $108 per month in the future. That means it will take you 64 months (5 yrs, 3 months) before you start to save anything. Be sure you plan on keeping this home long enough to recoup that cost.

Q: I currently have 26 years left on my mortgage and want to pay it off in 15 years. Should I refinance to a 15 year term?

A: That depends. If the new rate is more than 1% lower than your current rate, closing costs are reasonable and you plan to stay in the home longer than five years, this could be a good idea. But you still need to do the math.

Using our previous example, the payment on a 30 year mortgage at 3.5% is $898 but the payment over 15 years, even with a lower rate of 2.5% is $1333. It may be harder to qualify for the higher payment and financial circumstances can change over the years.

Compare making extra payments to your current mortgage and see if that works out better. For example, if you pay $1333 (an extra $435 per month) on your current mortgage, the extra payments will allow you to pay off your mortgage in 14 years and 7 months. By just paying extra, you avoid the refinance paperwork PLUS you will save at least a few thousand in closing costs! NOTE: Most lenders allow you to prepay but contact them first to be sure the payment is applied to principal.

Q: Is it a good idea to refinance from an adjustable-rate mortgage to a fixed-rate mortgage?

A: This is usually a good idea, but there are exceptions. If you have an adjustable-rate mortgage, or ARM, your monthly payments will change as the interest rate changes. With this kind of mortgage, your payments could increase or decrease. If you don’t plan on staying more than five years in the current home, and you have a low rate that can’t go much higher in 5 years, refinancing may not be worth it.

But peace of mind is important too. If you plan on staying in this home and you have many years left on the mortgage, you may be more comfortable switching to a fixed-rate mortgage. Contact your current lender to get the exact details of how high your rate could go and how often it can change. If you can get a fixed rate close to your current rate, it may be worth the closing costs to refinance.

If you currently have an ARM, will the next interest rate adjustment increase your monthly payments substantially? You may choose to refinance to get another ARM with better terms. For example, the new loan may start out at a lower interest rate. Or the new loan may offer smaller interest rate adjustments or lower payment caps, which means that the interest rate cannot exceed a certain amount. If you are refinancing from one ARM to another, check the initial rate and the fully-indexed rate. Also ask about the rate adjustments you might face over the term of the loan.

Any ad for an ARM that shows an introductory interest rate should also show how long the rate is in effect and the annual percentage rate, or APR, on the loan. If the APR is much higher than the initial rate, that is a sign that your payments may increase a lot after the introductory period, even if market interest rates stay the same.

Q: Should I refinance to get cash out for repairs?

A: Home equity is the dollar-value difference between the balance you owe on your mortgage and the value of your property. When you refinance for an amount greater than what you owe on your home, you can receive the difference in a cash payment (this is called a cash-out refinancing).

Before you refinance, compare the payments and costs for a home equity loan or home equity line of credit as options, that may save you money in the long run. Note: We don’t recommend cash-out refinancing to pay down unsecured debt (such as credit cards) or short-term secured debt (such as car loans).

Q: My current loan has a prepayment penalty. What does that mean?

A: This is a fee that lenders might charge if you pay off your mortgage loan early, including for refinancing. You should carefully consider the costs of any prepayment penalty against the savings you expect to gain from refinancing. Paying a prepayment penalty will increase the time it will take to break even.

Q: I plan to move in five years. But the rates are 1% lower, should I refinance?

A: It is not unusual to pay 3 percent to 6 percent of your outstanding principal in refinancing fees plus there may be fees due to your first lender for early payoff.

Q: What will refinancing cost?

A: The interest rate is the cost you will pay each year to borrow the money, expressed as a percentage rate. An annual percentage rate (APR) includes the interest rate plus what it will cost you to borrow the money. The APR can help you compare costs quickly. For example, a 2.6% rate with a 2.9% APR will likely cost you less in the long run than a 2.1.8% rate with a 3.0 APR.

Q: What is the difference between interest rate and APR?

A: This is a fee that lenders might charge if you pay off your mortgage loan early, including for refinancing. You should carefully consider the costs of any prepayment penalty against the savings you expect to gain from refinancing. Paying a prepayment penalty will increase the time it will take to break even.