Should I Refinance?

When deciding whether to refinance, there are important factors you should consider before you proceed. For example, you need to consider the current interest rate in comparison with the rate on your existing loan. You will also want to look at the costs associated with refinancing; for example lender’s fees, appraisal fees, etc. By looking at the difference in interest rates and the costs associated with refinancing (securing the new loan), you can determine how long it will take you to recoup these costs, and whether it is a good time to refinance.

The old rule of thumb is that you should refinance when interest rates fall more than 2 percent. Anything less may not be worth your while. For example, suppose your home is worth $100,000 and you currently owe $90,000 on the mortgage, which carries a fixed interest rate of 8.5 percent. Your monthly principal and interest payment (excluding taxes, insurance and mortgage insurance) would be approximately $692. Now suppose the current interest rate for fixed-rate mortgages is 7 percent, 1.5 percent lower than your current mortgage rate. By refinancing, your monthly principal and interest payment would be approximately $598, a reduction of $94 per month. Sounds great! However, you also have to consider the costs associated with this refinance.

Let’s suppose the cost to refinance to this 7 percent fixed-rate mortgage is $2,350 (closing costs), which includes an appraisal fee, lender fees and pre-paid interest for fifteen days (other fees may apply; quoted fees for example only). How do you know whether it would be cost effective for you to refinance? You would need to take the closing costs to refinance and divide them by the savings in your monthly payment to arrive at the time it would take you to recoup these costs. In our example, it would take approximately 25 months to recoup the cost of the refinance ($2,350 / $94 = 25). The next question is, how long (from the date of refinancing) do you intend to live in your home? It you intend to live there for more than 25 months, then it may be cost effective for you to refinance. Anything less than 25 months and you would not recoup your closing costs (refinance costs).

NOTE: Income tax considerations are not factored into this example. You should check with your accountant or a tax advisor to determine the tax consequences of refinancing.

Another factor to consider when refinancing, if you refinance to a new loan with the same term as your original loan, is the amount of time you will be paying on your home. For example, if your original loan term is 30 years and you refinance to another 30 year loan, 5 years into your original loan, you could end up paying on your home for 35 years. However, statistics show that most people do not remain in their home for the full length of a 30 year mortgage; therefore, you’ll want to again consider how long you intend to stay in your home when deciding whether to refinance.

Refinancing Fees

If the time between your obtaining your original home loan and refinancing is not too great, some lenders may be willing to reduce or waive some of the fees. In addition, you may be able to roll some (or all) of the closing costs into your new loan; i.e., you don’t have the out of pocket expense of the closing costs, rather you pay them back over the life of the loan. However, you’ll want to be sure to compare the potential savings with the expense of paying off a higher principal balance, to determine which method is most cost effective for you.

Equity

Equity is the difference between what your home is worth and the amount you owe on your home. There are two methods of achieving equity in your home: equity through loan payoff and equity through appreciation.

Equity through loan payoff occurs as you pay down the principal on your mortgage. For example, if your original loan amount is $100,000 and through monthly mortgage payments you payoff $2,700 of principal in the first three years, you would have a remaining loan balance of $97,300. Your equity in your home would be the $2,700 reduction in principal balance. (NOTE: appreciation is not considered in this example.)

Equity through appreciation (the rise in value of a property over time) occurs as the market value of your home rises over time. This rise in value can be the result of rising home values in your area and/or the result of improvements you make to your home over time. For example, let presume you purchased your home for $100,000 three years ago and that properties are rising in value an average of 5% per year. After three years of home ownership, your home would have risen in value by approximately $15,000 and now be worth $115,000. (NOTE: for simplicity, compounding effects not considered in this example.)

Now, what would be your total equity in your home after three years, combining the above two examples? First you would have paid your loan balance down by $2,700. Second you would have realized $15,000 in appreciation. Therefore, your total equity would be $17,700 ($15,000 + $2,700).

Home Equity Loans

Home equity loans are simply another way of refinancing your home in order to pull cash out of your property. Typically, a lender will allow you to borrow against the equity you have in your home, including equity achieved through appreciation. Often times, lenders limit home equity loans to a percentage of the home’s value, referred to as a loan-to-value (LTV) ratio. The typical LTV for home equity loans used to be 80%. However, with today’s strong economy and rapid property appreciation occurring in many areas, many lenders are offering home equity loans that exceed the standard 80% LTV. Some lenders are offering home equity loans up to 100% and even 125% of your home’s value. However, beware of these types of loans, for several reasons: 1) you will start at ground zero (or even below ground zero with loans in excess of 100% LTV) in terms of paying off your mortgage and building equity, 2) typically the higher the LTV, the higher the interest rate and 3) the interest on any amount you borrow in excess of your home’s value MAY NOT be tax deductible (check with your accountant or tax adviser).

Using the above example (Equity section), we said your home would be worth $115,000 after three years and you would owe a balance of $97,300 on the mortgage. Based on this scenario, you would have a loan-to-value ratio of approximately 84.6%. Under a standard equity loan of 80% LTV, you would not be able to refinance your home and pull out any cash. However, as we indicated above, many lenders will allow you to refinance up to 100% (and above) of your home’s value.

With all of the different types of refinancing options available to you today, be sure to take time to shop around and speak with several different lenders before making a decision. Examine the expenses of refinancing and the benefits to you, and find out what is expected of you in advance. And don’t forget to speak with an accountant or tax advisor to find out about the tax ramifications of refinancing (will all of the interest be tax deductible?). I believe the more you educate yourself, the better decision you will make around refinancing your home.

I would be happy to refer you to one of our preferred lenders to discuss refinancing options. Simply give ME a call and I’ll be happy to assist you.