When And How to Refinance

When And How to Refinance


Homeowners typically think of refinancing when mortgage rates dip. Refinancing means redefining the terms of your mortgage with a loan term that is different from what you currently have (could be either shorter or longer) and more importantly, to reduce interest rates from where they are at currently. There are also other reasons to refinance, which could be to migrate to a fixed rate loan and to raise equity. Understanding when and how to refinance can save a lot of money and may help to achieve the next deal. In fact, many experts think that these months can be one of the best times to do so.

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When you refinance, you are essentially applying for a fresh new loan. This would involve going through the whole rigmarole of verification, documentation, and appraisal. When you close a loan, there is also the cost of closing it, which could be anywhere from 2% to 3%, on a loan that is $200,000. So if your aim is to refinance to avail of lower interest rates, it would be prudent to take into account how much you would have to pay to close the first loan and how many months it would take to pay back that cost.

You can refinance your loan to either reduce the loan term, or extend the loan term. When you refinance a loan to reduce the loan term, your payments are likely to be higher, even if your interest rates have been reduced, only because the amount of time you have to pay the loan off is now shorter. This is still a good option to consider if you have the extra money every month to afford the higher payments because you would be paying less total interest over the period of the loan.

On the other hand, if you extend your loan period, you would be paying less every month, but more money by way of interest over the extra months or years that you have chosen over the original time frame. Getting at least a half percent drop in your interest rate should be the goal. Even if you choose a longer time frame for your refinanced loan, you could still try to pay extra every month so that you gradually close the gap between your new time frame and the old one.

It is always better to go in for refinancing after a few years of paying off the interest on your loan. This is because the first few years of a loan payment  almost always pay off the interest and not the principal balance, so it would not be cost effective to refinance immediately or within just a few months of taking up a loan. Once you have paid off a little bit of the interest, and then refinance, the amount of money you pay monthly will be lower because of both the lower interest you get on your refinanced loan and also because you have already paid off a significant amount of interest from your old loan.

You can also refinance your existing home to buy a new investment property. Since you need at least 20% of the cost of a new property as down payment, and other expenses like repairs, closing costs, etc., you would need a considerable amount in hand when buying a new property. You can make up this amount without having it as savings by refinancing your home up to 95%. When you opt for a cash out refinance, your mortgage is refinanced to an amount that is enough for your current mortgage, all closing costs, as well as extra money to put up as down payment for a new property!

To figure out when it would be economically prudent to refinance, here are some pointers:

  • The best time to refinance is when interest rates are low as that is when you have maximum savings.
  • Compare two scenarios-first, when the terms of the old loan and the new loan are the same and second, when the length of the refinance is the same as the new loan.
  • Closing costs of a new mortgage are also high, so calculate how many months of lower payments it will take to compensate the closing costs.
  • Input your cost and term of loan and you will get the number of months it will take to get back your closing costs.

Choosing a mortgage is probably one of the most important financial decision you will make. You should get all the information you need to make the right decision. Ask questions about loan features when you talk to lenders, mortgage brokers, settlement or closing agents, your attorney, and other professionals involved in the transaction. Keep asking and researching until you get clear and complete answers.

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