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| Cash and Debt ManagementRefinancing Your Mortgage* Read this section if you own a home - and current interest rates are lower than your mortgage rate.
Reasons To Refinance
There are three main reasons that may motivate you to refinance your existing mortgage. The primary reason is to save money because interest rates have dropped below the rate that you currently have on your mortgage loan. A secondary reason you may refinance is to raise capital, or simply put, to borrow additional money from the equity in your home during the refinancing process. Another compelling reason to refinance results from a balloon mortgage coming due, which forces the borrower to obtain another loan.
Declining Interest Rates
Anyone who has ever obtained a mortgage loan will probably agree that one of the most nerve-wracking experiences in their life was watching mortgage interest rates ebb and flow as they gambled on when to lock-in a rate on their loan.
Interest rates have historically been very volatile. The mortgage industry has become quite competitive. As a result, homeowners can take advantage of the competition and bargain down rates and costs.
Raising Capital
You may be able to borrow money as part of the refinancing process, provided you have enough equity in your home -- much like a home-equity loan. This can make good financial sense, because under most circumstances, mortgage interest is tax deductible. The best part is you may be able to keep your monthly mortgage payment the same as before you refinanced, even though you have borrowed some cash.
Here’s an example:
Current 15-Year Mortgage New 15-Year Mortgage no cash out New 15-Year Mortgage borrowing more money
| Principal |
$100,000 |
$100,000 |
$112,000 |
| Interest Rate |
9.5% |
7.5% |
7.5% |
| Monthly payment |
$1044 |
$927 |
$1044 |
| Additional amount you can borrow |
|
|
$12,000* |
As you can see from the above example, when you refinance your current mortgage at a lower interest rate, you can borrow an additional $12,000 and still keep the same monthly payment. Can you think of reasons you may want to raise capital through refinancing? Here are a few good reasons:
- Financing improvements to your home.
- Consolidating debts; paying off higher-rate consumer debt, such as credit cards, or an auto loan.
- Starting a business.
If one of your reasons was to pay for a vacation, you are not on the right track. Remember that you could be jeopardizing the security of your home by frivolously increasing mortgage debt.
Refinancing to raise capital makes sense if you want to keep your loans consolidated and have one monthly payment. It also gives you the benefit of being able to spread the payment out over a longer number of years if you need to.
CAUTION!: Although a longer payment period keeps your monthly payment lower, it increases the total cost of the mortgage.
Be careful not to overextend yourself and be sure to plan for emergencies. In the section titled "Tapping the Equity in Your Home", you’ll find a detailed discussion of tapping the equity in your home. The section also contains examples that can help you determine if you can take out additional money when you refinance.
Getting Into A Different Type Of Loan
Sometimes, saving money or raising more money is not always the objective in a refinance. You might be forced to get a new loan. Balloon loans, which come due and payable in full at a predetermined time, may require you to get a new loan. When a balloon loan comes due, you will do the same type of investigation that you would if you were getting a brand new loan.
Adjustable (ARM) To Fixed-Rate
Refinancing to go from an ARM to a fixed-rate mortgage can be comforting. The peace of mind knowing that your mortgage payment won’t fluctuate with changes in interest rates may allow you to sleep easier. A fixed-rate mortgage is most beneficial for those who plan on staying in their homes for a number of years. Of course, it may not make financial sense to do this if the cost of the fixed-rate loan is higher. We will cover this in more detail later on.
Adjustable To Another Adjustable
It may be very tempting to want to switch into another ARM when lenders offer very low introductory rates, called teaser rates. With a teaser rate, your first year interest rate and monthly payments would be significantly lower; but, if you plan on staying in your home for more than one year, the second and subsequent year rates will probably be the same or (more likely) higher than the rate you would have had on your original ARM. So be cautious when considering this!
Fixed-Rate To Adjustable
If you plan on selling your home within the time period that the ARM adjusts (one year, two years, etc.), it may be good for you to go from a fixed-rate mortgage to an ARM. For instance, say you are looking at a 5-year ARM. The mortgage rate on that loan will not change until the end of the fifth year. If you are pretty sure that you will sell your home within the 5 years, you may save money by doing this.
30-Year To 15-Year Loan
There are advantages and disadvantages to moving from a 30-year loan to a 15-year loan. Let’s take a look at some.
Advantages to 15-Year Loan Disadvantages to 15-Year Loan
|
| Interest rate is usually lower. |
Your monthly payment is higher -- make sure you can afford it. |
| Allows you to pay down your mortgage faster and build equity in your home. |
Depending on the economy and how long you plan to stay in your home, building equity may not be your best investment. |
| Provides a forced discipline of putting more money each month toward paying down debt. |
Reduces financial flexibility... with the higher monthly payment, there is less money around each month. This could be a problem if a financial emergency comes up. |
Refinancing: 15-Year Mortgage Versus 30-Year Mortgage
The example below compares the potential savings that will result by refinancing a 30-year mortgage to a 15-year mortgage with a lower interest rate or to another 30-year mortgage with a lower interest rate.
|
| Term |
30-year |
15-year |
30-year |
| Original Loan |
$95,500 |
| Principal to Refinance (outstanding balance) |
$92,800 |
$92,800 |
$92,800 |
| Interest Rate |
10.125% |
7.25% |
7.75% |
| Points |
|
0 |
0 |
| Monthly Payment |
$846.92 |
$847.14 |
$664.83 |
| Years Remaining |
26 years |
15 years |
30 years |
| Payments Remaining |
$264,239 |
$152,485 |
$239,339 |
| Amount Saved Over Life of Loan |
|
$111,754 |
$24,900 |
Keeping the loan at a 30-year payment period significantly decreases the monthly payment from $847 to $664 and saves you money over the life of the loan. This works great if you are looking to reduce your expenses or you are looking to have more money to invest.
Of course, you must also consider how long you intend to remain in the house. If it will only be a short period of time, an analysis of the cost of refinancing (there is a cost to it) compared to the projected savings will need to be addressed.
HOT TIP! If you can’t afford the payment on a new 15-year mortgage, consider a 20-year term. 20-year loans are offered by many lenders.
When Does It Make Financial Sense To Refinance?
To determine if you should refinance you’ll need to:
- Gather information from potential lenders regarding interest rates, fees and loan types, and
- Evaluate the information to determine if the refinance makes financial sense for you.
By the term financial sense, we mean, ‘will it wind up saving you money in the long run?’ There are costs associated with refinancing a mortgage (see the section titled "Costs of Refinancing" below.) A refinance only makes sense when you will stay in your home long enough to recover the costs of refinancing. This period is called the break-even point. So, if you’ll only be in your home for a few years, it may not make sense to refinance. Take a look at the break-even point worksheet in this chapter. You’ll also need to evaluate whether or not it makes sense to pay points. See the section titled "The Point of Points".
The Costs of Refinancing
Let’s run down a list of the typical fees. We have provided you with a worksheet to fill in the information you get from lenders.
Costs of Refinancing Worksheet
Fill in This Worksheet When You Call Lenders
The Break-Even Point
Now that you have an idea about the costs associated with refinancing, you need to determine if it will wind up saving you money in the long run. If current rates aren’t that much lower than your existing rate, but you plan to stay in your house, you may still save money by refinancing.
Examine the calculation below which computes the amount of time it will take to recover the cost of refinancing, i.e., break-even point.
CAUTION!: If your break-even point exceeds the length of time you intend to stay in your home, don’t refinance! For example, if it will take 29 months to recover your refinancing costs and you plan to be in your home for 22 months, it will not pay to refinance.
Break-Even Point - Example
| 1. Current monthly mortgage payment |
= |
878 |
| 2. Minus: New mortgage payment |
- |
734 |
| 3. Equals: Pre-tax savings per month |
= |
144 |
| 4. Multiply by: Your tax rate (e.g. 27%) |
x |
27% |
| 5. Equals: Tax effect |
= |
39 |
| 6. Pre-tax savings per month (line 3) |
= |
144 |
| 7. Subtract: Tax effect (line 5) |
- |
39 |
| 8. Equals: After-tax savings per month |
= |
105 |
| 9. Total cost of refinancing |
= |
3,000 |
| 10. Divided by: After-tax savings per month |
/ |
105 |
| 11. Equals: Number of Months to Break Even |
= |
29 months |
What does this mean? If the homeowners in the example plan on staying in their home for 30 months or more, they will save money by refinancing. They will have gotten back the $3,000 it cost for the refinance in the 29th month. However, this analysis doesn’t take into consideration the time value of money. If the time value of money is factored in, the break-even point will be slightly longer.
The Point of Points
Lenders make money on mortgage loans in two ways: By charging you interest, which you pay each month when you send in your payment, and by charging you a ‘loan fee’, commonly called points, that are paid when you take out the mortgage loan.
Some loans are ‘no point’ loans which means that no money is collected up front. While this helps you with the cash that you need when buying the home, the trade off is that the amount of interest you pay each month will be higher. There are also some unique tax treatments in conjunction with points paid on a refinance as opposed to points paid on obtaining an original loan -- more on this later.
Sounds simple enough, but what does it mean to you? How do you choose between two different loans and decide which loan is cheaper for you?
One easy measure is to compare each loan’s annual percentage rate (APR). Each lender is required by law to provide you with this information. When trying to decide between two loans, generally the one with the lower APR will be the cheapest.
The problem is that the APR is computed as if you held the mortgage until you completely paid it off. What if you only intend to stay in this home or keep the mortgage for five or six years?
You’ll need to look at the effective annual interest rate (see below.)
HOT TIP!: Assuming equivalent APR’s on two mortgages, one with points and one without, the rule of thumb is that the no point mortgage will be cheaper unless you plan on holding your mortgage loan at least 9 or 10 years.
Rate Versus Point Comparison
Here is an example of the rate versus point comparison calculation. The loan with the lower effective rate wins.
Rate Versus Point Comparison
Example: Low Rate and High Points Example: High Rate and Low Points
| a) Interest Rate |
7% |
7.125% |
| b) Number of years you plan to hold the loan |
5 years |
5 years |
| c) Multiply (a) by (b) |
35% |
35.63% |
| d) Points |
2% |
1% |
| e) Add lines (c) and (d) |
37% |
36.63% |
| f) Divide line (e) by (b) to get the Effective Annual Interest Rate |
7.4% |
7.326% |
The effective annual interest rate represents the true annual cost of the loan over the period of time you intend to keep the loan. The effect of paying more points will diminish the longer you intend to hold the loan. Although this calculation will help you determine your best choice, it does not take into consideration the time value of money. If the time value of money is factored in, the effective annual interest rate would rise slightly as you pay more points.
HOT TIP!: Shop for the best deal. Getting a good interest rate with a minimum of closing costs is your first objective. Choose the loan with the lowest overall cost of borrowing. Select a loan structure that achieves your financing goal. Ask potential lenders to give you a "Good Faith Estimate" which will outline all of the costs associated with that lender's particular loan offering. You can then compare "Good Faith Estimates" from various lenders to be able to choose the best deal.
HOT TIP!: Mortgage lenders are in a position to help explain the various features and benefits of the lending programs they offer. Don’t be afraid to ask for help in understanding the many options.
The Process Of Refinancing
Now that you have determined that refinancing makes financial sense for you, you are ready to begin the refinancing process. Once you are familiar with the steps you'll take, it should help relieve the stress of refinancing.
Procedures Checklist
Here are the typical procedures you will encounter when refinancing
- Fill out an application.
- Ask your lender if fees and costs may be included in the loan amount.
- Get an Appraisal by an independent party.
- Determine what is tax deductible.
We will walk through each of these procedures later on.
The Application Process
After you find a lender that has a package that makes financial sense, it’s time to apply for the loan. The application fee can range anywhere from about $150 to $450. Some lenders may even offer deals to refund the fee once the loan is closed. In most cases, the fee is not refundable, so don’t submit the application until you are reasonably certain this is the lender you want. It’s also a good idea to get pre-qualified for the loan. Ask the lender before submitting the application if there is a pre-qualification program. The loan officer will tell you what you need to do to get this done; it could save you a hassle once you have submitted your application with the fee.
If you choose to refinance with your current lender because they can give you the best deal, you could save money on the fees. And the process can be smoother since the lender already has information about you. You also may not need to get a new appraisal on your home when you refinance to a fixed-rate mortgage with the same lender. However, this could be a rare occurrence in these days of fluctuating real estate values.
A full-blown credit history is not usually required in a refinancing. The lender will usually just check your existing credit file and do a simplified income verification. It is important that your mortgage payment record be in good shape.
Fees
Did you know that you may be able to include most, if not all, costs of refinancing in the new loan? Each lender has its own rules, so be sure to ask your lender how it handles these costs. Refinancing the costs makes it easier to go through the process because you won’t be required to come up with a lot of out-of-pocket cash. The most significant cost that you can include in the loan amount is the points. Instead of paying them outright, you can finance them with the principal amount. Just remember, there’s no such thing as a free lunch! Taking out a bigger loan will mean higher monthly payments.
Thanks to bank regulators, lenders must provide people who refinance with a reasonable estimate of settlement costs and fees associated with the loan, this is called a "Good Faith Estimate". They must do this within three business days after receiving your application.
Appraisals
An appraisal is necessary because lenders don’t want to lend you more money than the property is worth. They want to be sure that, if the property is sold, they will get their loan paid back.
In general, lenders are not usually willing to lend you more than 80 percent (sometimes as low as 70%) of the value of your property minus your outstanding mortgage balance. This gives them a cushion if the value of the property goes down. Some lenders have more lenient lending policies though, so it pays to shop around if one lender is not willing to work with you.
For example, let’s say you bought a home in 1987 for $187,000. You put 20 percent down and borrowed $149,600 with a 9%, 30-year fixed-rate mortgage. In 1991, when the interest rate was 7% on the same type of loan, you refinanced. Your heart sank when the bank required an appraisal, because you knew you paid close to top dollar for the home and that property values since 1987 had dropped quite a bit.
The appraisal came in at $157,000 and the principal balance remaining on the mortgage was $139,600.
The result: you were declined the refinancing unless you were able to come up with additional cash of $14,000.
| Value of the Home |
$157,000 |
| 80% of the Value |
$125,600 |
| Principal Balance Remaining |
$139,600 |
| Additional Cash Needed |
$14,000 | Unfortunately, this may be a reality for some people. Be aware of the appraised value of your home as you enter the refinancing process.
What Can You Deduct On Your Tax Return?
There are some special tax rules with regard to what costs can be deducted in connection with a refinancing. Let’s see what tax breaks you’ll get from Uncle Sam.
Interest and Points
Depending on what your motive was for the refinancing, there are several different ways the interest and points on the loan are treated for income tax purposes.
Motive
Interest
Points
| You simply refinance the balance of your original mortgage (you don’t borrow any additional cash.) |
All the interest you pay on the loan is tax deductible (for loans up to $1,000,000.) |
Points must be deducted equally each year over the term of the loan. |
| You take out additional cash for reasons other than to make capital improvements to your home. |
The interest on up to $100,000 of additional debt is fully deductible as home-equity debt. (If you are married filing separately, the limit is reduced to $50,000.) |
Points must be deducted equally each year over the term of the loan. If your loan exceeds $100,000, the deductibility of the points may be limited. |
| You borrow additional cash--above the principal balance of your original mortgage--to make capital improvements to your home. The loan is secured by your principal residence. |
You are not subject to the $100,000 debt limit and can deduct the interest on up to $1,000,000 of debt. (If you are married filing separately, the limit is reduced to $500,000.) |
The points are deductible in the year of the refinance.* Exception: if only a portion of the loan is used for the improvements, only the portion of the points related to the improvements is deductible in the year of the refinancing. The remaining points are required to be deducted equally each year over the term of the loan. |
What happens if this is your second refinance and you still have points left over from the first refinance that have not yet been fully deducted? You get a bonus!! You are able to deduct the remaining balance of the points in the year of the subsequent refinance.
This information should serve as a guide for you - to give you an idea of what’s tax deductible and what’s not. You should call your tax advisor to clarify anything you don’t understand and to verify that the information is still valid under current law. Keep in mind that tax laws are always subject to change, and that the tax information provided here could change at any time, so don’t take it for granted!
Article Content by Truebridge, Inc. All rights reserved. Copyright 2001-2010 |
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