Mortgage refinancing can improve your financial standing in a number of ways. Five of the ways you may be able to benefit are:
✔ Getting a lower mortgage rate and lower monthly payments to save you money and create financial breathing room.
✔ Converting from an adjustable rate loan to a fixed-rate loan to lock in a low rate for years to come.
✔ Reducing your loan term to become mortgage-free by retirement age or sooner.
✔ Consolidating a first and second mortgage with one loan to reduce total monthly payments.
✔ Refinancing a home equity line of credit (HELOC) before it undermines your personal finances.
Let's look at these strategies in greater depth.
Lower Rates and Payments
One reason to refinance is to reduce monthly payments and loan interest costs. Imagine you have a $225,000 loan balance with an existing rate of 5 percent and 25 years left on the note, but you can refinance at 4.1 percent for 25 years. The monthly payment would drop from $1,315 to $1,200 and the borrower would save $34,500 in interest over the life of the loan.
You’ll need to factor in closing costs and fees, but there are usually options to cover those in the refinancing in which you pay little or nothing up front.
Convert from adjustable to fixed
When rates are low and borrowers expect to be long-term owners, it often makes sense to refinance from an adjustable-rate mortgage (ARM) into a fixed-rate loan so the monthly cost for principal and interest is set for the life of the loan. This is good protection against rising interest rates.
It may also make sense to refinance from one ARM into another. According to Freddie Mac, at the start of October 2014 you could get a fixed-rate loan for 4.19 percent while a five-year ARM was available for 3.06 percent. This means the “start rate” lasts for five years and results in a lower monthly cost. For instance, a $100,000 mortgage at 4.19 percent over 30 years requires a monthly payment for principal and interest of $488.43. With the ARM, the comparable monthly cost is $424.85 – at least for the first five years in this example. That's a difference of $63.58 per month and $3,815 over five years. ($63.58 x 60 = $3,814.80). After five years, of course, the ARM rate can move up or down.
For borrowers who have had a good start rate and face a higher interest cost when the loan is first adjusted, it may also make sense to refinance into another ARM loan rather than a fixed-rate mortgage with higher monthly costs.
Refinancing for Retirement
Retirement is a time when incomes generally decline. For this reason, borrowers might want to refinance to assure they are mortgage-free when they reach retirement age.
For instance, Johnson is 45 and has 25 years left on his 30-year mortgage. His current interest rate is 4.7 percent and the balance is $175,000. If he refinances with a new 30-year mortgage at 4.19 percent, the monthly payment for principal and interest will be $854.76. However, if he wants to retire at age 60 – or if he simply wants his monthly mortgage payment to end by that time – he might also refinance with a 15-year mortgage. In this case, the rate – according to Freddie Mac – would be 3.36 percent, so the monthly payment would be $1,239.05.
With the shorter loan, Johnson has higher monthly payments but gets three advantages: First, he is making mortgage payments while he's in the workforce and able to cover his costs. Second, if he sells or refinances before 15 years he owes a lot less to the lender. Third, his overall cost in interest goes from $132,713 with the 30-year loan to $48,029 for the 15-year mortgage. That’s almost $85,000 in savings.
Combine Two Loans into One
Before the mortgage meltdown, borrowers often financed with two loans such as an 80 percent first loan and a 15 percent second. The problem is that the second mortgage may have had a higher rate and – more importantly – it may have had a shorter term, say 10 years. For many borrowers, the second mortgages are actually balloon notes with a huge payment due at the end of the loan term.
The strategy here is to refinance both the first and second loans and replace them with a single 30- or 15-year mortgage. In this situation, the balloon note disappears because it has been refinanced. At today's rates, the borrower will have a significantly lower monthly cost.
A 2014 study by TransUnion estimated that nearly two million borrowers with home equity lines of credit – HELOCs – could face default and foreclosure.
HELOCs allow people to borrow against the equity in their homes. If you put the money back, you can borrow again in the future. In effect, a HELOC is much like a credit card with a given balance limit. With a typical HELOC, there might be a 10-year draw period when money can be taken out against the line-of-credit and then a five-year pay-down period when no withdrawals are allowed and all the money must be repaid.
You can see the problem. Imagine that you owe $60,000 in home equity debt and must repay the entire amount over five years. At 4.19 percent, the monthly payment will be $1,110 – a figure that might be completely unaffordable. The alternative? Avoid foreclosure and refinance into a single loan to replace both the existing first loan and the line of credit.