When interest rates are at record lows, refinancing a mortgage is a tempting proposition. But refinancing is a complicated financial transaction that involves closing costs, appraisals, home insurance, credit scores, and other details. Here are 10 questions homeowners should ask before refinancing a mortgage:
• Can the homeowner lock in a lower fixed rate while interest rates are favorable?
The biggest incentive to refinance a mortgage is to lock in a long-term interest rate that may be lower than future interest rates.
The struggling economy over the past couple of years has caused mortgage interest rates to plummet. The Federal Reserve encourages lower interest rates as an incentive to increase borrowing and get the economy moving again.
Now may be the best time for homeowners to refinance their mortgages because interest rates will go up when the economy improves.
• Does the homeowner plan to stay in the home long enough so they can earn back the closing costs?
Closing costs vary on loans to refinance a home, but for homeowners planning to move within a year or two, it may not make sense to refinance. If the closing costs are $1,000, for example, and the monthly savings with a lower interest rate is $50 a month, it would take 20 months to cover the closing costs and start realizing the savings.
• Will refinancing shorten the duration of the loan and still make the monthly payments affordable?
A 15-year mortgage usually carries a lower interest rate than a 30-year mortgage and saves thousands of dollars in interest payments due to the shorter term of the loan.
But a homeowner must decide whether the higher interest rate on a shorter-term mortgage is affordable. If the current mortgage payment is $1,200 a month, for example, and the mortgage payment on a 15-year loan is $1,500 a month, a homeowner on a tight budget may not be able to afford that additional $300 a month.
• Is the gap between the current interest rate and the new interest rate big enough to make refinancing worthwhile?
If refinancing would gain only a modest drop in the interest rate, then it may not be worthwhile to redo the mortgage. A homeowner with an interest rate of 4.5 percent, for example, would not realize much savings by refinancing at a rate of 4.3 percent. But cutting the interest rate to 3 or 3.5 percent may be beneficial. The key to finding the best interest rates is much the same trying to find the best home insurance rates or car insurance rates – shop around! Comparing rates from many different companies is the best way to ensure that the refinance rate is the best one currently available.
• Will refinancing allow the homeowner to afford a fixed-rate mortgage that will get rid of an Adjustable Rate Mortgage (ARM) or balloon payment?
A homeowner with an Adjustable Rate Mortgage or balloon payment may want to refinance the mortgage when fixed-rate interest rates are low. In these cases, refinancing lowers the risk of facing an interest rate bump with the certainty that the interest rate will remain the same for the duration of the loan.
An ARM or a mortgage that requires a balloon payment of the balance due at the end of a certain time period like three years often make mortgage payments affordable for people whose incomes may be too low to qualify for a fixed-rate mortgage. A balloon payment forces a borrower to refinance before the end of the loan term. With ARMs, the interest rate is tied to economic indicators and could go up if they increase
If interest rates go down for fixed-rate loans or the borrower’s income goes up, it may mean they could qualify for a less risky fixed-rate loan.
• Is the borrower’s credit score good enough to qualify for a new loan?
The recession caused banks to tighten their lending standards significantly so higher credit scores now are required to qualify for a mortgage. Minimum credit scores needed to qualify these days are 650 to 700. A high credit score means the borrower always pays all of their debts on time and never misses a payment.
If the credit scores of borrowers has improved, they may qualify for a new loan even if they did not meet the standards in the past.
• Can the borrower consolidate other debts like credit cards with higher interest rates?
A refinanced mortgage may allow the borrower to receive extra cash that can be used to pay off credit cards or other debt with higher interest rates.
Whether a bank will lend more than the current mortgage amount depends primarily on whether the homeowner has enough equity in the home to qualify. A homeowner who owes $100,000 for a mortgage on a $300,000 home, for example, probably could receive money above the $100,000 payoff amount, if they have a good credit score.
While borrowing against home equity to pay off these kinds of debts may be a good short-term fix, it may not be a wise financial decision in the long run. That’s because it refinances short-term credit card debt over 15 or 30 years, which means the borrower could end up paying much more in interest over the longer term.
• Does the homeowner have only a few years left on the mortgage?
A homeowner with a mortgage than is nearly paid off won’t save money by refinancing because the mortgage term will be extended by 15 or 30 years.
A homeowner who owes $25,000 on their mortgage, for example, may have the mortgage scheduled for payoff in five years. With refinancing, the loan payment would be much lower, but the term of the loan would be extended with much higher interest costs even at a lower rate.
• Will refinancing help the homeowner afford another major purchase?
A homeowner with enough home equity can borrow more than the current mortgage to finance a new car or home remodeling project. Financing a new car purchase with mortgage refinancing can be advantageous when car loan rates are high. Using the new mortgage to pay for a remodeling project can increase the home’s value.
An advantage to financing a car or home improvement with a new mortgage is that mortgage interest is tax deductible while interest on other loans are not. But the downside is that the cost is spread over 15 or 30 years and the borrower ends up paying much more interest over the longer term. Getting a separate home equity loan over a shorter term may be a better solution.
• Would it be better for the homeowner to keep the current mortgage and make higher payments on the principal?
Even if a homeowner can afford a shorter term loan, it may be better simply to increase the principal payments on their current loan. The savings on closing costs of a new loan can be applied to the old mortgage.
The portion of a mortgage payment that goes toward the principal is very low during a mortgage’s early years. A homeowner who has been paying for 10 years on a 30-year mortgage will be putting a lot more each month toward the principal than a homeowner with a new 30-year mortgage.
During the early years of a mortgage, it’s easy to double the principal payments each month because most of the payment is interest. Doubling the principal payment for several years can significantly reduce the term of a loan. Homeowners also can apply lump sums such as tax refunds to the principal.