The HARP refinance program has enabled millions of low- and negative-equity homeowners to save billions of dollars by...
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By Kirk Haverkamp
Updated and reviewed Nov. 26, 2014
Whether or not you are a homeowner, you’ve probably noticed a great deal of discussion about mortgage refinance. If you have ever wondered exactly what is involved in a refinance and how you can benefit, this guide should be helpful.
Refinancing your mortgage can help you to achieve the following
- Take advantage of lower interest rates that will lessen your monthly mortgage payments.
- Decrease the length of your mortgage to pay it off faster and save on interest charges.
- Increase the length of your mortgage and spread out the costs for lower monthly charges.
- Change the terms of your mortgage from an adjustable rate mortgage to a fixed-rate mortgage or vice versa.
- Refinance for a higher loan amount and get quick funds for home renovations, college tuition, medical costs, or other expenses.
What is a Refinance?
Basically, you're taking out a new mortgage and using the proceeds to pay off your old one. In other words, you're trading out your old mortgage for a brand new one with more favorable terms.
When you first purchased your home, the financial environment and factors like your credit rating and the amount that you could pay for a down payment influenced the interest rate that you were eligible for.
If your financial situation since then has improved and/or interest rates are lower, you can probably benefit from going through the refinance process and trading up to a better mortgage.
Knowing exactly when to refinance, what approach to take, what benefits to expect, and whether or not it is ultimately worth it can be confusing and intimidating. This is especially true if you are a first-time homeowner who is still shell-shocked from the process of getting a mortgage in the first place.
Also, while a refinance can save you money, there are substantial costs involved—another reason to seriously weigh your options to figure out if a refinance is ultimately worth it for you.
This guide will help you to understand the process of refinancing, the types of refinance available, and the benefits and pitfalls of refinance. It will also help to set your expectations on the process. Mortgage refinance generally has long-term benefits. If you’re expecting a short-term return, you will likely be disappointed. However, in the long run, a refinance can do a lot to improve your personal finances.
Your home is your largest asset and your biggest financial responsibility. Be careful with it! This guide is meant to educate you on refinance, but every situation is unique. Before taking any actions, consult a trusted financial advisor to help you to sort through the various options and figure out the best strategy for your situation.
What is a refinance?
The term “refinance” is a bit misleading. While it sounds like you are somehow reworking your old mortgage, you are actually taking out a new mortgage and using the proceeds to pay off your old mortgage. In other words, you’re trading out your old mortgage for a brand new one.
When does it make sense to refinance?
To really take advantage of the benefits of a refinance, it’s important to time it correctly. Here are a few ways to know if the timing is right
How is refinancing different from my original mortgage?
Actually, they're very similar. You go through the same process of applying for the loan and pay many of the same fees. The main difference is you're not buying a home this time around.
- If you have a fixed rate mortgage and the rates have fallen to levels below the rate that you are paying.
- If you have an A.R.M. and rates are starting to rise.
- If you are less than ten years into your current 30-year mortgage and rates are lower than what you are paying now. If you have been paying your mortgage for longer than that, you are currently paying more principal than interest. If you get a new mortgage, you start the cycle over again and will be paying mostly interest again, which may not make sense.
Is a refinance worth it?
The easiest way to figure out whether or not it’s worth it to refinance is to use one of the many available online refinance calculators. They will help you to determine how long it will take to recoup the expense of refinancing with the new savings.
People often refer to this as the “break even” point, which basically means that you figure out how much you will be saving each month and compare it to the cost of the refinance to figure out how long it will take to recoup your money.
The rule of thumb is that, if you plan to stay in the house long enough to recoup the entire cost of refinancing, then it is worth it.
How is the process different from getting your original mortgage?
The refinance process is very similar to the one you went through when getting your original mortgage. It is the same process of inspections and the same round of closing costs and fees. In most cases, an appraisal will also be performed on your house. The only real difference is if you are responsible for a prepayment penalty.
If you fumbled any part of this process due to inexperience the first time around, this is your chance to learn from your mistakes and come out ahead.
What are some of the main benefits of a refinance?
Saving money is the primary reason that most homeowners decide to refinance, but there are many other benefits. Here are a few of them:
Smaller monthly payments with a lower interest rate
When you first purchased your home, you may not have qualified for the best rate due to the financial environment at the time, as well as your personal finances. Since then, market rates may have fluctuated and, hopefully, your credit and other finances may have improved. Whatever the case, you may be able to get a lower interest rate on your mortgage, which will mean lower monthly payments for you.
Shorten or lengthen the payoff term of a mortgage
Shorten the term: In a nutshell, shorten the length of your mortgage, pay it off sooner, and owe less in interest payments over the life of the loan. This many mean that your monthly payments are actually higher, but the amount you pay in the end will be lower.
Let's say, for example, that you originally had a 30-year mortgage and have been paying it off steadily for eight years. Thanks to mortgage refinancing, you can switch to a shorter term of 10, 15, or 20 years. This can save you thousands of dollars of interest. Also, if the refinance rate is lower, but you maintain the same monthly payment, you will build up equity in your home more quickly, because more of your payment will be going towards principal.
Paying off your mortgage loan in 15 years rather than in 25 can save you tens of thousands of dollars in interest over the life of the loan. If you can afford the higher monthly payment and plan to stay in the home indefinitely, it's well worth it.
Alternately, you can also lower the length of your mortgage as well as your interest costs without refinancing by paying extra on the principal every month. Refinance or not, it’s a good idea to try to squeeze in an extra mortgage payment or two every year if you can afford it.
Lengthen the term: If you are having trouble making your monthly payments, you can increase the length of your mortgage and bring those monthly payments down by spreading out the costs over a greater number of years.
What are the potential benefits of refinancing?
- Lower interest rate
- Lower monthly payments
- Shorten or lengthen your mortgage term
- Convert from adjustable to fixed-rate mortgage
- Borrow money with a cash-out refinance
While there are short-term benefits to this strategy, you will end up increasing the amount of time that you are paying your mortgage and therefore the amount of interest that you owe.
Optimize loan structure by moving from an A.R.M. to a fixed-rate mortgage (or vice versa) or to switch to a different kind of A.R.M. loan.
A.R.M. to fixed-rate: An adjustable rate mortgage is exactly that, a mortgage whose interest rate can adjust depending on the market—which in turn can make your monthly payments change. If you have an A.R.M. and are uncomfortable with the unpredictability of payments, sense that the rates are about to change, or your initial fixed-interest rate is about to expire, you might want to move to a fixed-rate mortgage. One strategy is to figure out how much you can afford for a fixed rate mortgage and then wait for that rate to become available.
Fixed-rate to A.R.M.: Perhaps you have a fixed-rate mortgage, but you'd like to take advantage of the more flexible options of an A.R.M.. This is generally a move made by an experienced homeowner who has an expert understanding the market and can afford a fluctuating monthly payment.
Getting a different A.R.M.: If you already have an A.R.M. and predict that the next interest rate change will adjust your interest rates substantially; you may want to change to an A.R.M. with different terms.
Raise money with a cash-out refinance
One way to put more money in your pocket is to tap into the equity that you've invested in your home with a "cash-out" refinance. In this scenario, you can raise the funds you need by taking out a loan that's larger than your current one. As soon as you pay off the old loan, the excess funds can be used to pay for home improvement projects, college tuition, your daughter's wedding, long-term care expenses, etc..
The downside to this type of refinance is that you lose equity in your home. Equity is the amount of your home that you actually own, or the difference between what you owe and the value of your property. If you take out more than you owe, it will take time to build up your equity again.
The other thing to remember is that you are actually increasing your overall level of mortgage debt. Perhaps you will get a better interest rate, which will keep your new payments in line with the old ones, but that is not always a given.
If you are carrying a good deal of credit card or other debt, you can lower your monthly repayments through consolidation. To do this, you take out a mortgage loan large enough to pay off all the debts on your cards plus the balance on your old mortgage.
For example, if you have a $150,000 mortgage and $35,000 in credit card debt and car loans, you would attempt to get a $185,000 mortgage and then use the extra $35,000 to pay off the other debts.
Mortgage loans generally carry a much lower interest rate than credit cards and other forms of consumer debt. Coupled with the fact that mortgage interest payments are generally tax deductible, your debt will immediately decrease.
Also, by consolidating, you will be making one payment per month rather than several, which will enable many people to streamline their finances.
The downside to this is that if you default on your credit card payments and you wreck your credit. Default on your house payment and you may lose your house.
Increase your principal to avoid paying Private Mortgage Insurance.
If you were not able to pay 20% down on your home when you first purchased it, you probably have to pay private mortgage insurance (PMI) every month in addition to your mortgage payments to secure your loan.
If you now own at least 20% of the equity in your home, you may want to refinance your loan in order to stop paying the (now unnecessary) monthly PMI expense.
Cash-in refinance: On the other hand, you may find that even though you did make a 20% down payment when you purchased your home a few years ago to avoid PMI, your home value has depreciated and you now have less than 20% equity. In this situation, you may want to refinance to take advantage of low rates but also want to avoid having to pay PMI. In this case, you may opt for a cash-in refinance where you actually pay more upfront to get your equity back up to 20%.
Another option here would be to refinance through the federal HARP initiative, described further down this page
Again, this isn’t the only option to increase your equity. You can also make extra mortgage payments.
Some other types of refinances
Many specialized types of refinance are also available. If you don’t think that you will qualify for a refinance, it’s worth looking for options like these:
VA streamline refinancing, otherwise known as the Interest Rate Reduction Refinancing Loan (IRRRL) is a VA backed refinance option that does not require an appraisal or an underwriting package. If you already have a VA loan for your primary mortgage, this might be a good option. You can learn more about this on our page about VA loans.
Home Affordable Refinance Program (HARP)
If the value of your home has declined and as a result you are unable to refinance your mortgage, you may be eligible to refinance through HARP, the government-backed Home Affordable Refinance Program. It is designed to help people in low- or negative home equity take advantage of lower mortgage rates that they might not otherwise be able to qualify for. HARP also allows you to refinance without PMI if you don't have it on your current mortgage.
This program is scheduled to expire at the end of 2014, so you want to be sure to apply well in advance of that deadline.
FHA Short Refinance
If you owe more on your mortgage than your house is worth, the FHA Short Refinance may allow you to refinance into an FHA Loan—if your current lender agrees to a principle reduction, that is, accept less than the remaining balance owed on the loan. Current FHA home loans are not eligible. Borrowers who have been most successful in getting approved for this program have been those with so-called "exotic" loan types that were popular before the crash and are at high risk of default, such as interest-only loans and option ARMs. Read more about FHA mortgages.
Some reasons not to refinance
Though it may seem on the surface that a refinance is always a good course of action, there are times when it is definitely not to your advantage:
It will ultimately be too expensive
If you only plan to stay in your home for a few more years, you may not break even after paying the costs of the refinance before you move out. There are many online calculators that can help you to figure out your “break even” point.
Also, if you plan to extend the life of your loan to lower your monthly expenses, you should check to see what the total interest is that you’ll be paying over the course of the loan. Ultimately, your house is going to cost far more if you stretch out your payments, in which case it might be worth it to stick it out on a monthly basis—especially when you add in closing costs.
You’ve had your loan for a long time
If you’ve been paying off your mortgage for many years, you are now paying more of your principal than interest. By refinancing, you start that process again and most of your monthly payment will now be dedicated to paying down interest and not building new equity in your home—sort of a step back. Not to mention that sometimes that late in the process, you will not break even with the refinance charges.
Some mortgages have a prepayment penalty for paying it off early, and that includes refinancing, which is essentially paying off your mortgage early. Again, you have to figure out whether or not you are breaking even with the penalty charges if your lender will not waive them—and sometimes they will.
Consolidating credit card and other debt
While using a mortgage to pay off high interest debt like credit cards is a great idea, you have to be sure that you can keep up with your payments. Defaulting on unsecured debt in the form of a credit card is not great for you credit, but defaulting on a mortgage where your house is the security could lead to foreclosure. If you know that you’ll quickly run up your credit card debt again, that is another reason that consolidating your debt might not be the best idea.
Taking cash out for an investment
While this is a strategy often pursued by savvy investors, it can be a dangerous one for the typical homeowner. While a cash-out refinance is a low-interest way of borrowing money, keep in mind that it can also put your home at risk if you go bust. You don't want to go this route unless you're confident you can still afford your new, higher mortgage payments even if the investment doesn't work out.
Is a second mortgage a better option than a refinance?
While a refinance is a great way to get your finances in order, sometimes a second mortgage (home equity loan) can accomplish many of the same objectives. Here are a few of the goals of getting a refinance:
- Lower your monthly payment
- Shorten your pay-off term
- Optimize your loan structure
- Consolidate your debt
- Fund large, one-time expenses
The first three can only be accomplished with a refinance. The last two-consolidating debt and funding one-time expenses-can be accomplished with either a refinance or a second mortgage.
To decide between a refinance and a second mortgage, compare your mortgage interest rate with current market rates. If you're paying more than what's available, a refinance will lower your overall interest costs. If you're paying less, a second mortgage might be the better option. When the two rates are roughly comparable, many borrowers prefer the efficiency of a refinance-one loan, one monthly payment. It's also worth noting that refinance loans generally carry lower interest rates than second mortgages.
How do I know if I am eligible for a refinance?
Just because you were able to get a mortgage in the past, it isn’t a given that you’ll automatically be eligible for a refinance. First of all, you need to qualify for the new mortgage in much the same way that you originally qualified. For that, the lender will consider your income, assets, debts, value of the property, and the amount you want to borrow. After all of that, you’ll have to see if you actually qualify for the lower rate, which will make or break the whole refinance.
One situation that prevents many people from refinance is owning a house that is “underwater” or has fallen in value and is not worth as much as the homeowner owes on the mortgage. In this situation, many lenders will not agree to a refinance.
What are the tax benefits of a refinance?
A refinance isn’t cheap or free, and oftentimes the costs outweigh the ultimate savings. Just determining if you will break even with the costs isn’t the whole picture, though. To really understand the numbers, you have to figure out how the taxes work.
Tax deductions and refinancing
The IRS designates two types of mortgage debt: home acquisition debt and home equity debt. Home acquisition debt is what you paid to buy the house. When you refinance, the amount of the new loan used to pay off the old loan qualifies as home acquisition debt. Any amount over that would be home equity debt.
Here’s how that works: Suppose Jenny owes $200,000 on her mortgage. She takes out a new mortgage for $225,000 and pays off her old mortgage. For tax purposes, $200,000 is home acquisition debt, and the remaining $25,000 is home equity debt. Interest paid on home acquisition debt is generally tax deductible in its entirety. You can also deduct interest paid on the first $100,000 of home equity debt.
Tax Deductibles and points
In the same year that you refinance, you can deduct the points you paid down on the mortgage rate. Unlike points on your first mortgage, these points must be deducted over the life of the loan. So, if you have a 15-year mortgage, you need to deduct 1/15 of the points per year.
If you have refinanced more than once, you can deduct unclaimed points from an earlier refinance if you haven’t already taken advantage of them. For example, say you refinanced in 2008 and paid points and began deducting 1/15 of these points in the following years. If you refinanced again in 2010 to take advantage of good rates or you sold your house, you could take advantage of the unused portions of the points at that time.
Mortgage Interest and Tax deductibles
As an existing mortgage borrower, you already know that your mortgage interest is tax deductible. You may also know that you pay far more interest in the early years of a mortgage than you do later on. And the more interest you pay, the higher your deduction. Replacing your current mortgage loan with a refinance might lower your tax liability. And if you intend to use the refinance to consolidate credit card debt, the benefits would be even greater, because you'd be replacing non-deductible credit card interest with tax-deductible mortgage interest.
Taxes on cash out refinance: Federal tax rules state that if you borrow money against the value of your house for improvements i.e. cash out refinance to renovate, the interest you pay on that part of the debt is tax deductible as long as the debt is not greater than $1 million. If you use that money to pay off credit cards, take a trip, or buy a car, only the interest on the first $100,00 is deductible and none is deductible if you file under the alternative minimum tax.
Confused? Don't worry…your tax advisor will happily clear things up. The short of it is that refinancing can help you manage your tax liability and save you even more money than you thought possible.
What are the outright costs of a refinance?
You can expect to pay anywhere from 3-6% of your outstanding principal in fees. Additionally, you will be paying for prepayment penalties (if you have any) as well as any other costs. There are a variety of closing costs (which you are probably already familiar with), but the most common are:
- Application Fee
- Loan Origination Fee
- Discount Points
- Appraisal Fee
- Title Search Fee
- Title Insurance Fee
- Prepayment Penalty on Existing Mortgage
The first three listed above are within your lender's control; the others are not. If you have great credit, you might be able to negotiate lower application fees, loan fees, and discount points. Be cautious if a lender offers to cover your closing costs; this may mean you'll be charged a higher interest rate.
Should I refinance?
Be sure to weigh your long-term savings from refinancing against the upfront fees you have to pay to get the loan. If it takes too long to reach the "break-even" point, refinancing might not be worthwhile.
Closing costs have been known to change at the last possible moment. Your best protection against unpleasant surprises is to request a written estimate. Also find out what the lender's policy is on closing cost changes; some lenders guarantee their estimated costs, and others don't.
If you're refinancing just to save money, be sure to weigh the closing costs against your monthly savings. If the new loan saves you $50 monthly, but you have to shell out $1,200 in closing costs, it will be two years before you break even.
If it sounds too good to be true, it usually is. When it comes to the term “no-cost” this is definitely true. What this term generally refers to is a situation where the fees are folded into the loan or the lender ends up paying the fees and charging a slightly higher interest rate. Either way, you are paying the fees. Be sure to check the monthly costs and terms to truly determine if a no-cost option is right for you. One way or another, you are going to end up paying the costs and it might be cheaper to pay them up front.
Combine Two Mortgages into One Through Refinancing
Many homeowners have taken advantage of the equity in their homes to acquire second mortgages in the form of home equity loans or home equity lines of credit. In some cases, a secondary loan has helped them avoid closing costs, private mortgage insurance, or higher rates charged to jumbo loans. And sometimes, using an equity-based loan allowed them to fund a home improvement project, finance the purchase of a car or swimming pool, pay off credit cards, or help pay year-end taxes in a convenient and easy fashion. But if your loans carry higher than necessary interest rates, it may be a good idea to do a mortgage refinance and simplify your financial life with a single, low-interest rate mortgage.
Refinancing can help!
Although financial advisors may admonish you not to put all your eggs into one basket, when it comes to consolidation of outstanding obligations, most would agree that one basket to encompass all your loose ends is the preferred way to go. With interest rates still hovering near record-setting lows, there's no time like the present for homeowners to take out a single low-interest rate mortgage, in order to dispense with any higher-interest loans you may have on your books.
Save money through a mortgage refinance
The interest you can save by securing an attractively priced fixed-rate mortgage will lower your monthly payments and also cut substantial amounts of interest off the life of your loan. By tallying up the long-term costs of a first and second loan, and then subtracting the cost of a single mortgage obtained through refinancing, you can get a clear picture of your potential savings. In most cases, you can save an astonishing amount of money, which will more than pay for the incidental expenses incurred through refinance charges. Plus, they may be tax deductible.
It's a great idea to simplify your life by combining two mortgages into one. Then, you can save the multi-tasking for your office.
By now, we’ve hopefully taken some of the mystery out of mortgage refinance. Most people realize that refinancing is a way to lower monthly payments through better rates. What they don’t realize is that a refinance can be part of a smart strategy to streamline personal finances by reducing long-term debt.
Take a big step towards renovating your finances by looking into refinancing options today!
More Refinance Articles & Resources
- Streamline Refinancing
- No Cost Refinance
- Refinancing FAQ
- FHA Refinance
- Should I refinance my home mortgage?
- Federal Reserve (external)
- U.S. Department of Housing and Urban Development (external)
- U.S. Department of Treasury (external)
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