What Is Refinancing?

With the recent historically low interest rates there was a record surge of people refinancing their mortgages. If you are still in the process of considering, or buying a home, you may be wondering, “what is refinancing?” If you do own a home you may be wondering, “when should I consider refinancing my mortgage?” Let’s take a look at both questions and the issues you’ll want to work through to determine when, or if, refinancing is right for you.

When you buy a home you obtain a mortgage, also called a purchase loan by mortgage professionals. It’s simply a loan to purchase a home. The bank or financial institution making your mortgage charges you interest – a fee for borrowing their money. That fee is represented as a percentage of the total amount you borrow, for example, 6% or 7.15%. But here’s the catch – interest rates change. If the Federal Reserve cuts the prime rate (the rate at which banks can borrow money from the Federal Reserve) then consumer interest rates fall. That means that you may be able to get a mortgage with a lower interest rate than your current mortgage.

Less interest = a cheaper monthly mortgage bill = significant savings over the life of your loan.

When you refinance you’re getting a new home loan (at a lower interest rate) to pay off your old home loan.

Bank posters, web banners and TV ads scream “Save hundreds a month on your mortgage!” And who wouldn’t want to? But how do you know if it makes sense to refinance? There are three basic reasons to refinance:

(1)  You want to get a new type of loan.
You may have originally obtained an ARM (adjustable-rate mortgage), but would like the steady predictability of a fixed-rate mortgage. Or maybe you like having an ARM but want to lower your loan’s lifetime cap to reduce the highest possible interest rate you could ever be charged. Lifetime caps on ARMs are usually around 5 or 6%, meaning that your interest rate can never go 5 or 6% higher or drop 5 or 6% lower than the rate you locked in at purchase.

Let’s look at how refinancing an ARM would affect its lifetime cap. Let’s say the original interest rate on your ARM was 7.75% and you have a 5% lifetime cap. That means that your rate can drop to as low as 2.75% but can also go as high as 12.75%. Now if you refinance to a 6% ARM your lifetime cap can drop to as low at 1% and rise only as high as 11% — that’s a nearly 2% difference between the highest amount you could have to pay with your current loan and how much you could have to pay with a new, lower interest rate loan.

Or maybe you originally got a “balloon loan.” A balloon loan is a mortgage with an initial payment period at a low interest rate and then the entire balance of the mortgage due upon maturity of the loan. If your balloon is about to come due, you’ll have to pay off the entire remainder of the mortgage. If you’re not in a position to pay off the entire balance of the mortgage, you’ll want to consider refinancing to another type of loan to extend your payments over the full lifetime of the loan.

As you can see there are several cases where it makes sense to refinance not only to get a lower interest rate loan, but also a new type of loan.

2)  You want to tap into the equity you’ve built up in your home.
A home is most people’s biggest investment. And if you’ve been in your home for 10, 20, 30 years then you’ve built up some equity (savings) in your home. Maybe rates are low and you’d like to tap into that savings to help pay for a child’s college tuition; pay down debt, or make some home renovations. Refinancing to take some money out of your home is called a “cash-out refi.” Getting your hands on a little extra cash sounds enticing, but think twice before rushing to refinance.

First, remember that the money you take out of your home will be taxed as income so consider the tax implications before signing on the dotted line.
Second, be aware that your lender may charge a higher interest rate for a “cash-out refi,” because in essence you’re lowering the amount of savings you have in your home. Some lenders will add up to 1/2% to your interest rate if by refinancing you’re raising your LTV (loan to value) to 80 percent or more (meaning that you have 20 percent or less of your own cash savings built up in your home).

You can avoid the additional rate increase by either finding another lender who doesn’t charge a higher interest rate or you can take out slightly less cash from your home and keep your LTV at closer to 75%. Or you might want to consider other alternatives altogether such as obtaining a home equity loan, taking out a personal line of credit or looking into reverse mortgages as an option to tap into the equity of your home.

The higher the LTV, the less of your own money you have built up in your home. A 100% LTV loan means that you’re borrowing the total amount of the mortgage and have none of your own money invested. Lenders like to see homeowners have at least 80% LTV.

3)  You want to lower your interest rate and save on your monthly mortgage amount.
This is probably the most common reason people give for refinancing. It only makes sense – if you’re paying 8.5% interest on your loan and you have the opportunity to pay only 7%, why wouldn’t you? But there is more to refinancing than just the interest rate. There are a few things to consider and a little math to do before refinancing.