The most common reason for refinancing is to save money. Saving money through refinancing can be achieved in two ways:
- By obtaining a lower interest rate that causes one’s monthly mortgage payment to be reduced.
- By reducing the term of the loan, thus saving money over the life of the loan. For example, refinancing from a 30-year loan to a 15-year loan might result in higher monthly payments, but the total of the payments made during the life of the loan can be reduced significantly.
People also refinance to convert their adjustable loan to a fixed loan. The main reason behind this type of refinance is to obtain the stability and the security of a fixed loan. Fixed loans are very popular when interest rates are low, whereas adjustable loans tend to be more popular when rates are higher. When rates are low, homeowners refinance to lock in low rates. When rates are high, homeowners prefer adjustable loans to obtain lower payments.
A third reason why homeowners refinance is to consolidate debts and replace high-interest loans with a low-rate mortgage. The loans being consolidated may include second mortgages, credit lines, student loans, credit cards, etc. In many cases, debt consolidation results in tax savings, since consumer loans are not tax deductible, while a mortgage loan may be tax deductible. Please consult your tax advisor regarding tax deductibility.
The answer to the question “Should I refinance?” is a complex one, since every situation is different and no two homeowners are in the exact same situation. Even the conventional wisdom of refinancing only when you can save 2% on your mortgage is not really true. If you are refinancing to save money on your monthly payments, the following calculation is more appropriate than the rule of 2%:
- Calculate the total cost of the refinance–example: $2,000
- Calculate the monthly savings–example: $100/month
- Divide the result in 1 by the result in 2–in this case 2000/100 = 20 months. This shows the break-even time. If you plan to live in the house for longer than this period of time, it makes sense to refinance.
Sometimes, you do not have a choice–you are forced to refinance. This happens when you have a loan with a balloon provision, but no conversion option. In this case it is best to refinance a few months before the balloon comes due.
Whatever you choose to do, consulting with a seasoned mortgage professional can often save you time and money. Make a few phone calls, check out a few web sites, crunch on a few calculators and spend some time to understand the options available to you.