Gary Dek is a former investment banker and private equity analyst. Don’t hate him – he had nothing to do with the mortgage crisis and the recession. He writes at Gajizmo.com – check out his site sometime.
There are excellent reasons for refinancing a home, but before deciding to do so, homeowners should be aware of both the advantages and disadvantages that refinancing entails. Whether you want to get a lower interest rate, lower monthly payments or cash out equity in your home, there are times when refinancing may not be the best option for your investment.
Lower Interest Rates
Whenever there is a significant drop in interest rates, homeowners rush to banks and mortgage companies seeking to refinance their primary residence’s mortgage as well as investment properties. Over the life of a 30 year loan, saving 1% on mortgage interest translates to tens of thousands of dollars. This can mean lower monthly payments and can make your home more affordable, particularly if you are struggling to pay your bills because you are feeling house poor. Lower interest may be a good reason to refinance your home, especially if you have a good payment history for at least two years.
Homeowners who had a fair credit rating when they obtained their current mortgage may get lower interest on refinancing if their credit score has increased to good or excellent. High credit scores usually get borrowers the lowest possible interest rates. So what is considered a good credit score? If you have 650 or above, you should be able to get one of the best rates, though 720 plus will get you the best and lowest interest rates.
Get More Favorable Mortgage Terms
Some homeowners opt for adjustable rate mortgages (ARMs) because the interest rates are lower than fixed rate mortgages for the first several years of the loan. Unlike fixed rate mortgages, the interest rates on ARMs rise over time and increase the amount of monthly payments. Some ARMs also have balloon payments that are due at intervals specified in the mortgage terms. Buyers with lower credit scores and small down payments may not qualify for a fixed rate mortgage and accept the terms of an ARM because it is the only financing available.
Refinancing to replace an adjustable rate mortgage with a fixed rate mortgage is usually a good idea since it keeps monthly payments stable and there are no balloon payments. Interest rates are so low now that anyone who hasn’t refinanced in the last 5 years should definitely research mortgage loan offerings before rates increase any further.
During the recent mortgage crisis, some homeowners lost their homes to foreclosure because they did not understand the mortgage terms and were not prepared to make balloon payments when they became due. Others were unable to pay substantially higher payments when interest rates increased. Getting better terms on your loan is a great reason to refinance.
Cashing Out Equity
There are times when cashing out the equity in your home makes sense, whether it is to meet a long term goal like sending a child to college or to make needed repairs or improvements on the home. If you have been making payments on a mortgage for more than 5 years, or if property values in your area have risen, you probably have at least some equity in your home. Your equity is the difference between the value of your property and the amount still owed on your mortgage.
The disadvantage of removing equity from your home by refinancing is that your debt is increased and it will take longer to pay off the home. Depending on the current interest rates and mortgage terms, you monthly payments may be higher on the new loan. Using the equity in your home to pay off other debt, like credit cards, can be a great use of the proceeds, but could put your home at risk of foreclosure if you default on your payments. If you default on credit cards or other debts and fall into bankruptcy, you may still be able to keep your house.
Bottom line – as long as you don’t refinance your home and use the money to buy an RV, jet skis, a sports car or some other depreciating asset, using low-interest funds to make investments or pay off higher-interest debt is a wise financial decision.
Cost of Refinancing
Applying for refinancing is a lot like applying for any mortgage. You may be unable to refinance if your credit score is poor or if your income has been reduced due to a change in employment. Most finance companies and banks require that applicants have a stable employment history and may require that the applicant have held the same job for one to two years. If your credit scores are lower now than when you originally financed the home, you could be approved at a higher interest rate than you are paying on the original mortgage, which obviously means you shouldn’t refinance.
Furthermore, there are points/fees associated with refinancing that are similar to closing costs when you purchase a house. Lenders require a new appraisal, title search and credit report and discount points may apply. There is also a loan origination fee and all of the costs are paid by the borrower. You may have to pay for mortgage insurance when refinancing. While some lenders roll these costs into your new loan, others will require that you pay the costs out of pocket when the loan is finalized.
Refinancing Upside Down Mortgages
In many areas, the average market value of homes has dropped in just a few years. If the value of your home has depreciated since you purchased it, you may owe more on your mortgage than the home is currently worth. Since most lenders require some equity for refinancing, you may not be able to get a traditional loan. There are government insured refinancing programs to help homeowners without equity find mortgages with better terms so you can lower your monthly payments and pay off your mortgage early.
While real estate values will likely rebound in the coming years, appraisers must use the selling prices of recently foreclosed homes as comparisons (comps) to determine the market value of your property. Since foreclosed homes typically sell for less than their original market value, this can drop real estate values in areas with a large number of foreclosures. If the value of your home is less than the principal on your mortgage, it may be smart to wait to refinance until housing values recover or you have more equity in the property.
Homeowners who need to refinance to avoid foreclosure or to lower their interest rates or monthly payments may be eligible for the Home Affordable Refinance Program (HARP) sponsored by the U.S. Treasury Department and HUD. The program is designed to help homeowners keep their houses and may provide refinancing solutions for those who have no equity or negative equity in their homes. Although the program originally only addressed mortgages guaranteed by Fannie Mae or Freddie Mac, it has been expanded to include some private mortgages.
Refinancing can be a good financial decision, especially when it helps families get better interest rates and save money each month. For some, refinancing may be a way to avoid foreclosure and stay in their home. It is important to consider the pros and cons before deciding to refinance your mortgage and to shop around for the best terms and interest rates.
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Check out more of Gary’s work at www.Gajizmo.com.