Should You Refinance Your Mortgage?
Mortgage refinancing refers to the process of taking a new mortgage and using some or all of the proceeds to pay off any existing mortgages on the property. Refinancing your home loan is the act of replacing an old loan with a new one. There are two types of refinance mortgages: the rate and term refinance, and the "cash-out" refinance. Both are described in more detail below. If you are facing foreclosure, refinancing may be possible, depending on your credit, your home’s equity and its appraised value.
Rate and Term Refinance
This type of refinance refers to obtaining a new loan to replace an old loan for the exact same amount of outstanding principal balance. No cash actually flows through the borrower, but from one bank to the other. For example, you have a current loan from Bank A with an outstanding balance of $200,000 at 6% interest, and the loan is coming due in a few months.
Rather than waiting for the loan term to come due, at which time the entire remaining balance of the loan would be due and payable to Bank A in one lump sum, you opts to refinance the loan with a rate and term refinance.
You would apply to the same lender, or a new lender, for a $200,000 loan, and when approved it would go to payoff the existing loan. If the loan is from a new lender, Bank B, the proceeds would go to payoff Bank A’s $200,000 loan, and you would continue making payments, this time on the new loan to Bank B.
Some borrowers don’t necessarily wait until the loan is due to refinance. If interest rates have come down, some borrowers might choose to refinance because a lower interest rate would save them money on monthly payments. A borrower would do this only if the new interest rate is saving him more money than it would cost to obtain the new loan. For instance, if the new loan saved the borrower $50 per month over 30 years, that would be saving him $18,000 over the life of the loan. As long as the new loan didn’t cost more than $36,000 in fees it would be a loan worth refinancing. The borrower must consider all fees to obtain the new loan including:
- Bank fees
- Origination points
- Broker fees (if any)
- Title costs
- Mortgage insurance (if any)
- And other third party fees normally associated with the closing of a new loan (legal, attorney, appraisal, etc)
Are there any tax issues to consider when refinancing?
For federal income tax purposes, you are generally able to deduct qualified interest you pay on a mortgage to buy, build, or improve your home, provided that the mortgage is secured by your home and meets certain dollar limits.
This is known as "home acquisition indebtedness" for tax purposes. Interest on new debt you incur to refinance your home acquisition indebtedness also qualifies, but only up to the amount of the refinanced debt.
Some Reasons to Refinance Your Home:
- To lower interest rate and monthly payment
- To change loan term (from 30 years to 15 years, for example)
- Possibly avoid foreclosure (very specific situations apply)
A cash-out refinance is one by which the borrower refinances his loan, but also takes a portion of his home equity out in cash. This type of refinance always increases your outstanding loan balance, and if you are refinancing at the same interest rate or higher, your monthly payments will likely increase as well.
You must have available equity from which to draw, and the loan must be within the lender’s maximum loan to value guidelines. Using the example above, if your home with a $200,000 loan had a market value of $300,000 you would have approximately $100,000 equity. Your current loan would be at a loan to value (LTV) ratio of 67% ($200,000 / $300,000). Most lenders will allow a cash out of 80% LTV, which means you could be approved for as much as $240,000 (80% X $300,000). It costs only $200,000 to payoff your existing loan so you would receive $40,000 in cash, to do with what you will ($240,000 new loan – $200,000 old loan = $40,000 cash-out).
Many borrowers use low interest rate cash-out refinances to payoff other high interest debt. Depending on the amount you borrow, there could be certain tax advantages for which you should consult an accountant.
The primary disadvantage of a cash-out is that you are increasing the outstanding loan balance, and likely extending the amount of time you will be paying your mortgage, and, over the life of the loan, the amount of interest you will be paying too.
Reasons to Perform a Cash-Out Refinance
- To payoff other high interest debt
- To complete home rehabilitation
For those who prefer stability in their loans, you might choose to refinance an adjustable rate mortgage (ARM) to a fixed term loan.
Also, If you are facing foreclosure beware of brokers and banks that charge outrageous fees to refinance your loan. Predatory lending is illegal, as is taking advantage of borrowers in these tough situations. There are several government sponsored programs to help keep borrowers facing foreclosure in their homes. The Home Affordable Refinance Program (HARP) is made available as a partnership with most lenders and the federal government. don’t be fooled by so called “mortgage consultants” and never give out any money to brokers as up front fees to refinance your loan or get you approved through the HARP program.