When Should You Refinance Your Mortgage?

Mortgage concept: Red pawns on the word mortgage spelledRefinancing a mortgage can be a good idea for any number of reasons. Many people decide to refinance because they can get a lower interest rate than the one they are currently paying. That lower rate means less money out of pocket each month. Then there are those who refinance for a shorter term on the mortgage, so instead of a 20-year loan you’re getting a 10 year term instead. In some cases, a lower interest rate can also come with a shorter term so you’re making fewer and cheaper payments.

Perhaps you’ve decided to shift from an Adjustable-Rate Mortgage (ARM) to a fixed rate mortgage where the interest rate you pay will either remain the same for the full term of the loan or it can fluctuate one way or another as you go. All of these are part of a “rate and term refinance” which is done in the interests of saving some money.

Some consumers choose to refinance because they want to withdraw cash against the equity in the home. This is known as a “cash-out refinance”. In this instance, you basically take out a brand new mortgage for an amount that exceeds what is currently owed. The extra cash you receive from this new mortgage can be used for anything.  Some consumers select this type of refinancing model to pay off the previous mortgage, pay down credit card bills, eliminate some other type of debt or lien, or just put that money in the bank to use for a later date.

Rate and Term vs. Cash Out Refinancing

When rates begin to fall, consumers start to consider whether or not it’s a good idea to refinance. The rate and term refinancing model enables the consumer to save up to a few hundred dollars every month now that they have refinanced with a lower rate and maybe even a shorter term on the loan, reducing the amount of time it will take to fully own the property. That money stays in your pocket at a smaller monthly loan payment while still paying off your new mortgage.

For example, up until now you may have been paying 6% interest on a loan.  After making payments steadily for three years on a 30 year term, you now have an opportunity to refinance for a rate of 4.5%. The choice is up to you to get a new mortgage at another 30-year term and save more each month, or save a little less and continue paying what’s left on your loan amount at the same term of 27 remaining years.

Cash out refinancing works a little differently. This this model, the money you save is put into your pocket in one lump sum. In order for this method to work, you must have sufficient equity in your home. You can use a simple formula to determine how much equity you have in your home.  Simply take what the house is worth (valued either based on recent comparable sales in your neighborhood or a formal appraisal), subtract what you owe on a mortgage and the result is your equity.

If the market value of your home is currently $250,000 and you owe $160,000 on your mortgage then you would have $90,000 in equity. At $160,000, you could possibly get approved for a refinance at $190,000. With that money you would pay off the $160,000 loan and leave you with an extra $30,000 in cash. You can spend that extra money however you would like and still retain the remaining $60,000 left in equity in your home.

In each scenario, money is going back into your pocket. Just how much at one time is entirely your decision. Do you want it to be a monthly savings or one large lump sum that gets deposited into your savings account?

The Federal Reserve: How it Affects Your Rate

The Federal Reserve, or better known as simply “The Fed”, is the governmental body tasked with implementing economic policies in this country in an effort to keep it healthy and thriving. That comes with regulatory powers over the nation’s banking system and the institutions that comprise it.

The defined mandates of the Fed are as follows: “to promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar and moderate long-term interest rates.” That last part – moderate long-term interest rates – is where the Fed can greatly affect how much you’ll be paying on your mortgage each month.

The Fed impacts the nation’s economy, inflation levels, and employment trends through implementing monetary policy.  One of the methods it uses to effectuate that influence is by adjusting the target for something called the federal funds rate. For all intents and purposes, this is what dictates what your interest rate will be on your mortgage.

It is important to keep in mind that word “target”, however. The Fed does not set the rates but merely a target position where it would like to see the rates.  The agency then performs various policy-related functions to help urge the rates towards its assigned target. The rate itself is established by our financial institutions, banks, credit unions, and other lenders that are part of the Federal Reserve system as they negotiate with one another individually.

Many different rates can come about as every banking entity works with each other separately.  The federal funds rate is then compiled via the average of all those rates that are independently established. That number can and will then affect all short and long term interest rates, including how much interest you’ll pay on your mortgage.

The Fed monitors the way the economy, as well as global financial indicators, is moving in any one direction and it can influence the federal funds rate by raising or lowering it depending upon the health of the nation’s economic status. In times of great economic distress, the Fed will often target a lower federal funds rate to stimulate growth and get the economy moving in the right direction once again.

When things are going well, the Fed may target a higher rate which, in turn, makes it more expensive for banks to borrow money which in turn means that it will cost more for customers to borrow from the banking institutions. Those increased costs are passed down to the consumers who are looking for loans.

Rates: Adjustable vs. Fixed

When you’re shopping around for a mortgage you have two options available to you where rates are concerned. Each has distinct advantages and disadvantages that make one more preferable over the other for different consumers.

The first is an Adjustable-Rate Mortgage, or ARM.  This type of loan is a great idea for some borrowers because the rates and payments are extremely low at the start of the term. However, like the name suggests, an ARM rate can fluctuate and increase rather dramatically over the duration of the term, possibly raising to nearly double the rate when you first started making your payments.

Conversely, just as the rates can rise they can also fall.  Many consumers don’t mind going for the ride because it avoids the headache and additional costs that come with refinancing when rates drop. If you have an ARM you can already take advantage of the lower interest rates when they come down. You can also use an ARM to your advantage by enjoying the lowest rates if you don’t plan on living in that home for very long. Many homebuyers will purchase the home they want with an ARM, relish in the low interest rates, and after a couple of years they can sell the house, pay off the mortgage, and move to the next place they want to be.

While all of these things sound good, an ARM has some drawbacks.  The biggest one is that fluctuating rate. When you’re in on an adjustable rate mortgage, the rate you’re paying can increase from an initial 4% or 5% and reach as high as 10% or even 11% towards the end of the term. The problem is you can’t fully predict what the rate will be over the long term because the Fed could target the federal funds rate dramatically in just a few years.

If the economy begins to soar, you may be paying higher interest each month. In addition, the rates you pay at the front of the term may only cover the interest that is due on the mortgage and don’t actually pay off any of the principal balance.  This could mean that you built significantly less equity in your home than you initially thought when it is time to sell.

Fixed rate mortgages are the opposite of an ARM in that the interest rate is locked in place and it will never change for the full term of the loan. Again, this option has some favorable aspects and distinct drawbacks.

For starters, a fixed rate can weather the economy so you’re protected in case interest rates suddenly skyrocket up due to inflation or any other volatility. It also makes budgeting your money easier since you know what you owe each and every month. With an ARM, that could very likely change from one month to the next. Of course, a fixed rate mortgage is much easier to understand for the most unseasoned of homebuyers. It’s all very straightforward and doesn’t require an education into the banking system to comprehend. Your rate at the start is your rate when the term ends. Plain and simple.

The biggest disadvantage to a fixed rate mortgage is trying to refinance when the rates do fall. You may like that fixed rate mortgage at 6%, but when you have the opportunity to get one at 3.5% you might just be thinking how much better that smaller number would be for your wallet. Refinancing can be a huge pain in the neck and end up costing you more money in closing costs, perhaps into the thousands of dollars. It might not be worth it, not to mention having to unearth all of the necessary documents and paperwork that is required to go through the mortgage process all over again. Fixed rate mortgages may also price some homebuyers out of the home they want with higher rates than an ARM.

While these pros and cons are all important to factor into your decision for going with one type of refinance over another, there are some additional circumstances you will also need to consider. Take some of these questions into account before you make your choice, as one type of mortgage scenario is often preferable when you find yourself answering these questions.

Short-Term or Long-Term Residence

As mentioned above, you will want to think about how long you plan on living in the home when you take out a mortgage. If the answer is just a few years than you will probably want to go with the ARM, especially if you can find a smart price on it and are relatively confident that interest rates won’t increase substantially in the near future.

Remember, these types of mortgages start out with low rates and low payments. Planning on living there for just a couple of years means you’ll be able to take advantage of both as you save your money to buy the house you really want later on. When you’re ready to leave, you’ll be out before the rate starts to increase.

If, however, you have found your ‘forever home’ and plan on settling down and staying put for a few decades, then select the mortgage that will provide you with the stability you will need.

Adjustments on Your ARM

Some ARM’s fluctuate differently, but the majority of them start to adjust at the same every year, typically on the anniversary date of the mortgage closing. This begins after however long your initial, fixed period happens to be, but an annual adjustment isn’t common with all ARM’s. Some may adjust every month. This is all based on the specific index for your mortgage and this can lead to an unpredictable and somewhat volatile financial situation. Some consumers prefer the staid and predictable situation of a fixed rate instead.

Check Out the Current Rates

At the time you’ve decided to apply for a mortgage, the first thing you’re likely going to check out are the current rates. This can also heavily influence your decision for choosing a fixed rate mortgage versus an adjustable-rate. If they’ve been set pretty low, you’re more likely going to want to pick the fixed rate option because once you’re locked in at a number like 5% or 6% that will be a great rate to be paying for the next 20 or 30 years.

However, let’s say the current rates are much higher.  In that case, it might make much more sense to get into an ARM. The lower initial rate will still allow you to get into the home you want and when rates do eventually fall, you won’t need to refinance your property in order to reap the benefits of having the rate automatically adjust.

Does Refinancing Make Sense?

So you’ve made the decision as to which mortgage you want to go with and we’ve even talked about the benefits of the types of refinancing models that are available. When does it really make sense to refinance, then? The answer is different for all of us, of course, but there are some basic determiners that apply to every situation.

Rates play a major role, obviously, and when interest rates suddenly begin to plummet that can be a very enticing reason to make the case for refinancing your mortgage. At first glance it may even be a no-brainer, but when you take other aspects into consideration the decision may not be so cut and dry.

The Rate Difference

How much is your interest rate at the moment? Now how far have rates fallen? Measure the two up against one another and you may be asking for more trouble than you first expected by refinancing at that lower rate.

This may sound odd but hear me out.  If the current rate has fallen by about 1% to 1.5%, that may appear great at first glance. However, once you factor in expenses like closing costs and other real estate fees that are part and parcel with a refinancing it may end up taking you years to recoup those costs.

Sure, that 1% is going to be make a big difference with a mortgage somewhere into the millions, but it won’t greatly affect you if yours is around $150,000. Once you’ve done all that work and paid the potentially thousands of dollars in closing costs, how long do you think it’s going to take to recoup that money by saving just 1% or 1.5%

That’s the key thing to think about here: the costs. You’re going to want to get that money back over time when you refinance. Therefore, it’s important to think about how much you’re really going to save and the length of time it will take until you break even on the fees.

Let’s say your closing costs after you refinance are $5,000. Your refinancing is going to save you about $150 a month. That means it’s going to take you about 33 months to make those costs back. Nearly three years. Take those same closing costs but with a saving of $325 a month and it’ll take you just 15 months. Now which of those scenarios is the better option? This is why it’s so important to really look at those rates and do the math before you decide if you want to go through the time-consuming, and costly, process of refinancing your mortgage.

Staying in Your Home

It’s a factor in which type of mortgage you choose, but it’s also an important circumstance for refinancing that mortgage. Deciding how long you plan to own the home can help you determine if refinancing is a smart move or not. The average length of time most people stay in their home is seven years. At that duration or even longer, you’re likely to find a better interest rate and recoup your closing costs in a reasonable amount of time.

Your Financial Picture

Refinancing is sometimes a vital necessity for homeowners who are struggling in the current economy. Maybe they’ve lost their job or two incomes have become just one.  Refinancing to save even a minimal amount on the mortgage each month may make the difference between keeping the home or getting foreclosed upon. In cases such as these, refinancing makes a lot of sense.  You may even want to explore other methods of refinancing that go beyond your typical mortgage with that 30 year payment.

Mortgage concept.What About Equity?

Another good time to refinance might be predicated upon how much equity you currently have in your home and what you might want to do with that money. As we’ve discussed, when you get into a new mortgage you’re essentially erasing the current one. Think about whether or not it’s really worth it to basically start over again with another 30-year term if you’ve been paying off the current one for the past five or six years already.

With just 25 years left does it really make sense to start back from square one again? It may be smarter to keep paying off what you currently have instead of adding more costs and paying off that interest again, particularly if the home doesn’t have a lot of equity in it already. It may result in you paying more than necessary over that period of time. Conversely, however, if you have little to no equity but you’re getting absolutely killed on a high interest rate than it may behoove you to explore your refinancing options.

Our Final Thoughts

Refinancing your mortgage can be a welcome opportunity to put more money back into your pocket every month. However, it does require some careful consideration first. Doing the math will often be the first indicator of whether or not you’re a prime candidate for refinancing the mortgage.

There are other important factors to consider as well. Given the different options available to you with respect to the types of mortgages you can get into, the decision can be a tough one. However, as long as you are able to answer a few questions about your current situation and the interest rate environment at the time you’re thinking about pulling the trigger on a re-fi, you should come out ahead after all is said and done.

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