For the 3rd time this month, I just had a conversation about refinancing mortgages. Mortgage rates are at some of the lowest we have seen in our lifetimes. I hear about rates at some local banks being 2.4% to 2.6%. I see online rates as low as 2.25%. Of course, you will need a good credit score to get these rates – certainly above 740.
Do you still have a mortgage or home equity loan with an interest rate above 4%? Especially with those who have interest rates above 4%, in some cases, even those with rates above 3% should consider refinancing.
Some reasons that I hear for not refinancing:
1 – But then, I am starting to pay all that interest again. Each regular payment that you make on a mortgage is part principal and part interest. The interest is calculated based on the outstanding balance, interest rate, and days since the last payment. Take an example of a $100,000 balance with interest last paid 30 days ago with a monthly payment of $750.
If the interest rate is 5%, the amount of interest for that payment would be $410.95. $750 less the $410.95 means that $339.05 would go towards the principal. If the interest rate is 2.5%, the amount of interest for that payment would be $205.48. If you make the same $750 payment, you would be applying $544.52 towards the principal.
The key here is to refinance without lengthening the term of the mortgage. Look at the option of a 20, 15, or 10-year mortgage, depending on the number of years left on the current mortgage. Keeping your payment around the same amount that you are paying with the original mortgage allows more to be applied to the principal with a lower interest rate.
2 – But then it will take me longer to pay it off. I just spoke of this. When you refinance, do not extend the length of the mortgage unless you have a reason to do so. Try to shorten the term. If you attempt to keep the payment close to what you are paying now and reduce the interest rate, you should be able to pay it off in the same amount of time, maybe even shorter. Avoid doing another 30-year mortgage. Do a 10 or 15-year or maybe a 20-year depending on how far into the original mortgage you are.
Additionally, another way to reduce the length of the mortgage even if you contract for the same length is switching from a monthly mortgage payment to a bi-weekly mortgage payment. By making ½ of the payment every two weeks instead of one monthly payment, you lower your overall interest in two ways. After making the 1st payment of the month, a lower amount of interest will be due for the 2nd payment. The outstanding balance would be smaller for the 2nd payment allowing for a lower interest calculation. Secondly, by making bi-weekly payments, you would make 26 payments in a year which is effectively thirteen monthly payments. Both factors shave years off the mortgage.
3 – But then I pay closing costs again. True! The question to ask yourself is, is the reduction in the amount of interest greater than the closing cost amount? We started this by saying the existing mortgage above 4% almost always works. The impact of the closing costs can be the determining factor of whether or not adjusting from the 3% or 3.5% interest rate to a lower rate makes sense. Here is where some math comes into play – what is the difference over the life of the mortgage in the interest amount between the old rate and the new rate? Is that amount larger than what you will pay in the closing costs if you refinance? That would be a determining factor as to whether or not refinancing makes sense. If your savings in interest is not greater than the closing costs, we would not recommend that you refinance.
There are other factors to consider.
- Do you have a relatively low balance that will be paid off in a few years? It might not be worth refinancing. Will the interest savings be more than the closing costs would again be the determining factor?
Is everything positioned correctly to enable a new mortgage application to be approved? Financial institutions are reviewing at least 2 years of income. While they are compensating for short-term unemployment if you returned to work at the same place, it could delay the approval. Will the value of your house appraise at the amount you need?
- Is your credit score positioned to allow you to get the best possible rates? If not, what can you do to raise that score before applying for a mortgage? Review your credit report at AnnualCreditReport.com. Clean up any incorrect information. Is there negative information that is correct but needs an explanation of what caused it? Get that information on file. Maybe there is negative information that will fall off shortly, and it makes sense to delay applying for a few months.
- Are you considering refinancing to pay off other debts? This often does not make sense. If you are taking a 4-year car loan and adding the balance to a mortgage where you will now pay interest for the next 10 or 15 years on that car, consider the impact of that carefully. Whether that is a car loan, a $10,000 credit card balance, or any other loan, when you add that outstanding debt to a mortgage, you are extending the length of time and the amount of interest that will be paid. Think carefully about refinancing and adding other debt into that new mortgage balance.
- The same is true about refinancing and taking cash out. What is borrowing that cash going to cost you? It might make sense if you have home improvements to do that will increase the house’s value. It might make sense if you use it to pay for a college education that will increase your earning power.
Consolidation loans – either through adding them to a mortgage, taking out a home equity loan, or taking out a personal loan have been popular for many years. The problem is we see individuals consolidate the debt and start running up new debt. It is essential if you consolidate other debt into your mortgage also to commit to not incurring new debt.
If you add other debt to your mortgage, consider how much your monthly debt payments are being reduced. Take the difference in the payments and either add that as extra principal payments to your mortgage or automatically put that amount into savings – or split the difference between the two.
Maybe instead of adding non-mortgage debt to a refinancing, consider extending the mortgage to the same term for a lower payment now. Take the difference to get the other debt paid off. Once the non-mortgage debt is paid off, you can add that cash as extra principal payments to shorten the mortgage payoff period.
Refinancing can be an excellent opportunity to allow you to pay debt off quicker. It can also jeopardize your future financial security if your house becomes a revolving source of securing more debt. When done correctly, the goals to reduce overall interest paid and shorten the length of debt can improve your long-term financial security. Planning with Purpose is here to help you navigate through refinancing. We can help you compare options, clean up a credit report, and make decisions regarding terms.