Refinancing allows you to change the terms of your mortgage, typically either the rate of interest you pay on the loan or the date it is due. Typically, but not always, borrowers refinance because they want to lower their monthly payments.
Say you took out a $250,000, 30-year mortgage with a fixed rate of 8% a couple of years ago, but you can now get a similar loan with an interest rate closer to 7%. To refinance, you take out a new loan with a lower rate and use the proceeds to pay off the old loan. Your monthly payment will fall by about $170 a month, saving you over $2,000 a year.
Another reason to refinance is to avoid an expected increase in the monthly payment on an adjustable-rate mortgage. Many adjustable-rate mortgages actually charge a fixed rate of interest for an initial period of between one and 10 years before the rate starts resetting. Sometimes this initial interest rate is set artificially low to entice borrowers. Once the interest rate starts resetting at prevailing market rates, the monthly payments can jump, making them harder to afford or even unaffordable.
By taking out a new mortgage, either another adjustable-rate loan with an initial, fixed-rate period or a fixed-rate loan, and using the proceeds to pay off the original adjustable-rate loan, you can keep your monthly payments from rising too much.
Even if you can’t get a better interest rate than the one on your current loan, you may be able to lower your monthly payments by stretching the payments over a longer period of time. Most mortgages today have 30-year terms, but it’s possible to find a 40-year loan. And if you have a 15-year mortgage, you may be able to lower your monthly payments by refinancing into a 30-year loan. While banks charge higher refinance rates on longer loans, you’ll be paying off less of the principal each month. The net result could be a lower monthly payment.
While most people refinance to lower their monthly payments, it’s also possible to save money over the long-term by refinancing into a shorter-term loan. This will raise your monthly payment, but it should get you a lower interest rate, all things being equal. And since you’re paying the loan back faster, you’ll pay less interest over the life of the loan.
You could cut the amount of interest you pay over the life of the loan in half. For example, if you take out a $150,000, 30-year mortgage with a fixed rate of 8%, and stay inyour home until the mortgage is paid off, you will pay a total of $2446,232.87 in interest. That’s right – you’ll be paying more in interest than you are actually borrowing.
By comparison, if you take out a 15-year loan of the same size with the same interest rate, you’ll pay $108,016.06 over the life of the loan. But your actual savings are likely to be even higher, since banks typically charge less interest on shorter-term loans.
Brian Brady, a principal at. World Wide Credit Corp., a mortgage broker based in San Diego, said that historically, banks have charged around half a percentage point less on 15-year loans than on 30-year loans.
Cashin’ In
Refinancing also allows you to cash in on an increase in the value of your home. This is much less common than it used to be, since housing prices have been falling for the past couple of years. But there are still some people who purchased their home 10 or 20 years ago and have accumulated a lot of equity in the property, either because the property has appreciated or because they’ve paid off a big chunk of the mortgage. They may be able to get a new, bigger loan, pay off the old loan and have cash left over.
Freddie Mac estimates that homeowners with loans owned or guaranteed by the finance company cashed out about $32 billion in home equity in the fourth quarter of 2008 and the first quarter of 2009. While that sounds like a lot, it was the lowest amount cashed out over two consecutive quarters in the past eight years.
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