With mortgage interest rates at such low levels, homeowners cannot avoid the chatter to refinance their loans and take advantage of interest rates before they start to move higher. At first glance, a mortgage refinance from a high interest rate to a low rate seems like a great way to save money. However, a refinance may not represent the best move based on your motives or situation. If you qualify, you can definitely receive a good rate, but need to consider the numerous costs associated with a mortgage refinance.
Failure to evaluate this aspect of mortgage refinancing can have you paying more in overall costs than if you keep your existing loan. Before you start the formal process of applying for a loan, carefully evaluate your financial circumstances and answer some important question to determine if a mortgage refinance makes financial sense.
Understanding Mortgage Refinance Costs
For some borrowers, refinancing into a low interest rate may cost just as much obtaining a mortgage to purchase a home. Common closing costs includes application fee, loan origination fee, points (about one percent of the loan amount), title search, title insurance, private mortgage insurance (government-insured loans), appraisal fee and prepayment penalties (one to six months interest).
Even if you apply for a “no fee refinance” loan, which means you do not incur out-of-pocket costs, you will pay the closing costs somewhere in the process. Usually, the mortgage lender adds the costs to the balance of your mortgage, which results in you paying interest on closing costs or a higher interest rate for the new loan.
Therefore, when considering a refinance, it’s vital to determine whether the savings you’ll realize from a lower interest rate offsets closing costs. Remember, closing costs vary according to the interest rate on the loan. Securing, the lowest available interest rate may mean you will have to pay higher closing costs. Conversely, a higher mortgage interest rate can lower your closing costs.
Taking into account closing costs and looking at some of the common reasons for refinancing can help you make the right decision:
1) Longer Amortization
Sure, you may be able to reduce your monthly mortgage payment by refinancing into a mortgage with a longer amortization than the time remaining on your current mortgage. However, if you have 10 or 12 years remaining on your current mortgage, refinancing to a new 20-year or 30-year fixed rate mortgage can be a big financial mistake because you end up paying more interest and taking on additional years of mortgage payments.
2) Save Down Payment for a New Home
In this scenario, you need to calculate closing costs to determine the expenses of a mortgage refinance and how much money you expect to save each month. If it takes you five years to recoup the costs associated with the refinance, but you plan to move in three years, you will actually end of losing money on the refinance.
3) Counting On Home Values to Appreciate
The S&P/Case-Shiller Home Prices Index reports the average U.S. home has loss nearly 34 percent in value over the last several. Many economists believe it will take more than ten years for prices to recover—assuming home values stabilize and the economy expands at a faster pace. The bottom line, if you base your decision to refinance your mortgage based on home prices going up anytime soon, you may be in for a long wait.
4) Unable to Qualify for Refinance
Unless you plan to refinance through one of the government-insured mortgage refinance programs, you will need to have at least 20 percent equity in your home. Lack of sufficient equity, including owning more on the loan than the value of their homes have prevented many homeowners from taking advantage of low rates.
If you have hard to verify income or a low credit score, expect to have problems refinancing your existing mortgage. Gather more than enough documentation to verify your income and obtain a copy of credit report and fix you credit before submitting a loan application.
5) Exchange ARM for Fixed-Rate Mortgage
Many homeowners will benefit by refinancing from an adjustable-rate mortgage to a fixed-rate loan. Ignore all the negative chatter about ARMs and evaluate the pros and cons of the ARM before you apply for a loan refinance. Start by reviewing the index, such as Treasury Bill, Certificates of Deposit, Prime Rate or Cost of Savings Index, the lender ties to your mortgage.
In addition, identity the three caps for interest rate adjustment: first cap, annual cap and lifetime cap. Calculate the caps and compare the total cost to the closing cost of the fix-rate mortgage to determine if refinancing your mortgage works to your best interest.