Navigating a Home Refinance

With interest rates as low as they’ve been, you may be wondering if it’s the right time to refinance.  While it seems like a no-brainer, the decision is a little more complicated than at first glance.

The big question these days is no longer who should refinance, but who can.  It’s no secret that the pendulum has swung from easy credit to more stringent lending rules, in many cases reducing the permissible loan to value ratio, limiting the amount of loan the bank will issue relative to the appraised value of the home.  Factor in the decrease in home values, and we have a more challenging refinancing environment than we did a few years ago.  Still, rates are very low, and for those with equity in their homes, decent credit, and sufficient income, it’s worth considering.

When weighing the merits of refinancing, an important factor is how long you plan to be in your home.   Refinancing can be costly, and you’ll need to measure the payback period.  If you’re planning to move in the next year or two, chances are there won’t be enough time for the savings in interest to offset the cost of refinancing.  The longer you plan to keep the loan, the more sense it makes.   In calculating your breakeven point, that point in time when the refinance starts saving you money, you must consider more than just the savings in interest vs. closing costs.  Many times homeowners will refinance a 30 year mortgage into another 30 year mortgage.  If you refinance ten years into your original loan, you are adding on an additional ten years of payments- assuming you live in that home for the entire life of the loan.  In that case, you will need to not only calculate how many months until you recover your closing costs, you must also look at how much you will have paid out in payments in all.  You may save on the interest side for that new loan, but overall you will have more years of payments.  If your goal is to save money, refinancing to a term equal to the years you have left may be a better plan.

On the other hand, if you plan to move before the end of the loan term, pick the year you are likely to move, and run two calculations:  one with the total amount you will have paid in payments from now until then and what your principal balance will be at in that year if you keep your current mortgage, and the same calculations with the new mortgage (adding the closing costs to the total amount paid), and compare the two.  How does the savings in payments stack up against where your principal balance will be?  Are you saving on the one hand, but ending with a significantly higher balance when you plan to sell, or is the savings more than enough to make it worthwhile?

Saving money in the long run may not be your goal though.  Perhaps it is to reduce your payment to ease a cash flow crunch, or to get extra cash for a home improvement project.  Before you start looking into options and calling lenders, you should know what you’re trying to accomplish.  That’s the first step, according to Holley Kearns, branch manager of National Penn Bank in Stroudsburg.  Kearns also recommends having a ballpark idea of what your home is worth, and preparing your income information ahead of time.  “It’s important to develop a relationship with a bank, someone you can go talk to,” she advises.  When you sit down with a lender, make sure they are willing to listen and give you counsel on your options, whether it is a traditional refinance, or refinancing with a home equity loan, or what loan terms would be most suitable for you.  It’s also a good idea to review your credit report ahead of time, clear up any errors, and be on your best financial behavior for the months leading up to your application.

You’ll find through the refinance process that although the headlines announce mortgage rates in the 3% range, not every loan carries that rate.  There are several factors that affect the interest rate you qualify for:  the length of the loan (shorter terms carry lower rates), your credit score, your income, and your home loan to value ratio.  For instance, a loan that is no more than 80% of your home’s appraised value generally garners the best interest rate, and your lender may be willing to go to a higher loan to value if you are willing to pay a higher rate.  Paying points can lower your rate, although less now than in the past.  A point is equal to one percent of the loan amount, and by paying a point (or more) or even a fraction of a point, you can buy a lower interest rate.  Points add to the total closing costs, so you’ll need to run those earlier calculations again, considering the additional cost vs. the lower rate.

No discussion of mortgages would be complete without mentioning closing costs.  Costs can vary between lenders, so when comparing rates be sure to ask about closing costs as well.  Looking at the APR (annual percentage rate) rather than just the interest rate can give you a general idea of how closing costs, points, and term length all affect your real costs.  With most refinances, closing costs will include an appraisal, title insurance, any points you choose to pay, and miscellaneous other fees like application or recording fees.  You may find a special deal from time to time offering low or no cost refinancing too.  Home equity loans in some circumstances can be used for a refinance, and those costs are usually much less, but may have a higher interest rate.   Closing costs are either paid at closing, or sometimes rolled into the loan.

As with all things finance, getting good advice for your specific situation is important.  Be sure to use a lender who will take the time to listen and advise you well.  Some solid parting words from Kearns:  If the first thing they do is pull out an application or use high pressure sales tactics, run the other way.

photo by: Tax Credits

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