Do The Math And Make The Right Decision.
Your home loan represents a major financial commitment — perhaps the biggest of your life — but it’s not set in stone. With good credit, you might be able to refinance your mortgage to lower your interest rate, reduce your monthly payment, or pull cash from the equity you have built up as you have made your payments.
To be clear, home loan refinancing is no simple matter. You are not renegotiating the terms of your mortgage. You are following a process that will completely replace your original home loan with a new home loan.
When you refinance, your new lender will pay off your original mortgage. In return, you are expected to honor the terms of the new agreement, and you are responsible for all the fees and other closing costs that come with it.
To determine whether you should refinance your home loan, you have to know where you stand and examine your own motivations for striking a new deal. Most importantly, you have to know whether the attractive terms offered by your new lender will reduce the total cost of your home.
The Reasoning Behind a Home Loan Refinance
There are three common reasons homeowners seek a home loan refinance:
- You want a lower interest rate or monthly payment. If your credit score has improved since you obtained your original home loan, you may be able to get a new loan at a lower interest rate. You may even be able to lower your monthly payment along with it.
- You want a fixed rate. If the low introductory rate on your adjustable-rate mortgage has expired, you may wish to switch to a fixed-rate mortgage. Conversely (and less commonly), you may wish to switch from a fixed rate to take advantage of a good deal on an adjustable rate.
- You want cash. By making payments on your original mortgage, you have built up equity, or ownership, in your home. You can leverage that equity by pulling cash from it with a refinancing model known as “cash-out” mortgage refinancing.
All three reasons are perfectly valid, including the desire for cash. You may wish to use that money on remodeling and other improvements that will raise the value of your home. You might also wish to use it to avoid taking out a personal loan, which would likely require a higher interest rate.
The Math Behind a Home Loan Refinance
Whatever your motivation, refinancing your home loan can be a great move, but only if it actually saves you money. Counterintuitively, a lower interest rate and a lower monthly payment can cost you money if your new home loan significantly extends the term of your original loan.
The reason is simple: The longer the term, the more payments you make. The more payments you make, the higher your “finance charge,” which is the total of your interest payments plus whatever closing costs are included in the financing.
Closing costs could include, but are not limited to, appraisal fees, title fees and credit reporting fees. Some closing costs are typically included in the finance charge, but others, including appraisal fees, are sometimes not.
But the mere fact that a home loan refinance costs money should not necessarily deter you. If you save money in the long term, it will be worth it. Consider this example borrowed from our recent article, How Does Mortgage Refinancing Work?
- Original terms: You purchased your home three years ago for $250,000 (including all closing costs, for simplicity’s sake) with a 30-year mortgage at a fixed 5% interest rate. Your monthly payments are $1,342.05 and your total finance charge is $233,139.46.
- New terms: You shop around (reaching out to a minimum of three reputable lenders or mortgage brokers) and are offered a new, 30-year mortgage at a fixed 4% interest rate, a full percentage point lower than your original home loan. Your new monthly payment is significantly lower at $1,137.96, and your total finance charge is $171,307.43.
- The reality: You are saving $204.09 every month and accumulating interest at a slower rate. That’s good! But you already made three years of payments totaling $36,672.93, and you’re essentially restarting the 30-year clock. That’s … bad? Or is it good? Let’s find out.
- The math: By adding the $36,672.93 you paid over the past three years to the $171,307.43 you will pay over the next 30, your total finance charge is $207,980.36. Subtract that from your original finance charge of $233,139.46 and you save $25,159.10 over the life of both loans. Not bad at all!
You can see how refinancing your mortgage may affect you with our mortgage refinance calculator.
If the numbers don’t work out in your favor, and there is no other compelling reason to refinance your home loan, it might not be the right move for you. So be sure to closely examine your financial situation and do the math before starting the process or committing to a new home loan.
Even if you are not considering a home loan refinance, you should know your credit score and take steps to prevent identity theft. Before you start shopping for a credit monitoring service, check out our recent entry on Decoding The Free Credit Report Sites!
Have you considered refinancing your auto loan? Vehicle refinancing may help reduce your interest rate, lower your monthly payment, or remove someone from your auto loan.