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7 questions to ask before you refinance

7 questions to ask before you refinance

Monthly savings shouldn't be the only consideration in determining whether to take advantage of today's rock-bottom rates.

Question: It seems like each week mortgage rates keep dropping. How do I know if it makes sense for me to refinance, and how much time do I have to decide?

Answer: How low can they go? For new homebuyers and current homeowners thinking about refinancing, it seems like the decline in rates just keeps on keeping on.

The average rate on a 30-year fixed mortgage currently stands at 3.67%, according to Freddie Mac, with the 15-year fixed mortgage averaging a previously unheard of low of 2.94%. Both are down more than 2.5 percentage points from where they stood four years ago. So shouldn't anyone with a mortgage rate above, say, 5% on a 30-year fixed loan look into refinancing? Not necessarily.

Figuring out whether refinancing a mortgage makes sense requires asking yourself several important questions. The first and most important is whether you qualify. Homeowners with low credit scores or who owe more on their homes than the property is worth might have trouble finding a lender willing to refinance their mortgage (the federal Home Affordable Refinance Program might be one option). For those who do qualify, here are some of the key questions to ask before queuing up in the refi line.

How much will you really be saving?
Finding out how much you'll save each month by refinancing is as easy as plugging the amount and length of the new loan into any online mortgage calculator and comparing the results with your current monthly payment. But the monthly payment should not be your only consideration. Remember that the bulk of early payments on a new mortgage typically go to pay interest on the loan. So by starting a new loan you're essentially restarting the process of paying off mostly interest (albeit at a reduced rate) and little principal.

You also might not be building up equity in your home any faster than you did with the previous mortgage. For example, a homeowner who takes out a $200,000 30-year fixed-rate loan at 5% pays more than $66,000 in interest in the first seven years of the loan. If, after seven years have elapsed, the homeowner refinances the remaining balance ($175,890) into a 30-year mortgage at 4%, he or she saves more than $230 a month in loan payments (from $1,074 with the old loan to $840 with the new one). At the same time, however, the amount of principal paid off also drops (from $3,260 in what would have been year 8 of the existing mortgage to $3,097 in year one of the new mortgage) while adding another five years of mortgage payments at the end of the loan. Had the borrower stuck with the original loan, he or she would have ended up paying about $186,000 in interest. But by refinancing and turning back the clock on the loan, he or she ends up paying about $192,000 in total.

Keith Gumbinger, vice president of HSH.com, a mortgage information website, says focusing on the monthly payment while failing to look at the big picture is one of the most common mistakes refinancers make. "If you're very deep in your mortgage, with under a dozen years remaining, or have a very small mortgage, [such as one worth less than] $50,000, you're not paying that much in interest anymore," he says. "The benefits of refinancing are slight."

The mortgage refinancing calculators at HSH.com and Bankrate.com are great tools for helping you decide whether refinancing makes sense for you.

When calculating monthly interest savings, keep in mind that interest on home mortgages is tax-deductible. So by saving, say, $100 a month in interest, you might only be saving about $75 on an after-tax basis (depending on your tax bracket and other factors). Also, by reducing the amount of interest you pay each year, your total itemized deductions could fall below the standard deduction amount, meaning that you can no longer take advantage of other itemized deductions, such as donations to charity.

What will you do with your savings?
If you hope to free up cash to pay down other debts--from a high-interest credit card, for example--that's fine. However, be aware thatchanging your spending habits will go a lot further in keeping your debt load manageable than refinancing will. Or, if you are thinking about pocketing the savings, consider using at least a portion to pay off principal on the loan. Doing so helps pay down the loan faster and could make a refi pay off in circumstances in which it otherwise wouldn't.

How long do you plan to stay in the home?
Remember that it will take time for the refi to pay for itself. If refinancing saves you $500 in interest per year but costs you $2,000 in points and fees, you'll have to stay put for at least four years just to break even. Sell the home before that and you've lost money by refinancing.

What type of mortgage makes the most sense?
If you plan to stay in your home long term, today's bargain-basement fixed interest rates are hard to resist. Don't be seduced by still-lower adjustable-rate mortgages unless you're reasonably confident you won't be staying in the home much beyond when the rate adjusts. The last thing you want is to be kicking yourself a decade down the road for not locking in the lowest rates when you had the chance.

Also consider the length of the mortgage. A 15-year mortgage will offer a lower rate and lower overall interest costs than a 30-year mortgage but higher monthly payments. If you're unsure whether you can afford the higher monthly payments, consider taking out a 30-year mortgage and including extra principal payments each month to pay down the loan faster and save on interest. Taking the 30-year mortgage ultimately might end up costing you more, but it buys you the flexibility to pay a lower amount each month in case you or your spouse lose a job or another emergency arises that requires you to free up some cash.

Do you plan to take cash out?
Refinancing at a higher amount than is owed on your existing mortgage can put money in your pocket, but it's not free. You'll still pay interest on the loan, and lenders have become more stingy regarding the practice. If the amount of the new mortgage is more than 75%-80% of the value of the property (referred to as loan-to-value) the lender may raise the rate and/or fees or decline the application altogether.

Are you better off paying points and fees or choosing a no-cost refi?
You might be asking yourself, "Don't I end up paying the same amount either way?" Not necessarily, says Gumbinger. He says that rolling refinancing costs into the loan's interest rate typically adds about half a percentage point, which could make it the more expensive option if the borrower plans to stay in the home for the full term of the loan. In that case, paying points and fees upfront and getting the lower rate will save more over the long haul. But for borrowers who plan to stay in the home for just a few years, the no-cost refi could be the better option if the additional cost from the higher interest rate is less than the cost of paying the points and fees upfront.

How soon do you have to decide?
The good news is today's low rates aren't likely to shoot higher anytime soon. "Every time we think we've found stability for interest rates, something else comes along and forces them down further," says Gumbinger. "We do think rates don't have much further to fall, but never say never." He predicts 30-year rates will hover around 4% by year-end.

If you do decide to refinance, prepare for a more involved process than if you had done so, say, five years ago. In the wake of the financial crisis, lenders have become much more careful about who gets loans. Make sure you check your credit score before applying to ensure there are no unpleasant surprises when the lender does its credit check. Also be prepared for more paperwork and longer waiting periods to close on a refinance compared with years past, with typical waits of 60-90 days.

Refinancing might be more work than it used to be, but for those who qualify, locking in at today's low rates could not only save tens of thousands of dollars over the life of the loan, it might offer them the satisfaction of knowing they took advantage of an opportunity that might not come again in their homeowning lives.