Refinancing is simply obtaining a new mortgage loan for your home and using all or part of it to pay off the old mortgage.
Does it make sense for you? Listed below are reasons refinancing might pay off, followed by tips on how to make refinancing a more profitable experience.
The Benefits of Refinancing
Cut your monthly payment.
The old rule said interest rates needed to drop 2 percentage points before you refinance. But as little as a half point might save you a lot of money if you plan to stay in your house five years more. If you have a mortgage of $100,000 at a rate of 8.5%, a new mortgage with a rate of 8% could save $35 a month. That's $420 a year and $2,100 over the next five years. If you invested that money every month your savings would be greater. Before you sign on the dotted line, you should consider the cost of refinancing and the effect of "restarting the clock" on your mortgage. Closing costs vary widely but can be as much as $1,800 on a loan this size.
To figure out how long it will take you to recoup that money, divide your closing costs by your monthly savings. In our example, $1,800 divided by $180 equals 10 months. If you plan to remain in your house for at least another year, it probably makes sense to refinance. Of course, if you take out another 30-year loan, you have tacked on more years before you'll be mortgage-free. You can take out a shorter mortgage (say, for 25 years) or go with the longer mortgage and invest the difference. Fold in a home-equity loan. Interest rates on home-equity loans are steeper than on first mortgages, so you may save money by refinancing a loan big enough to pay off your home-equity loan too.
Stop paying private mortgage insurance (PMI). If you put down less than 20 percent when you purchased your home, you are probably paying PMI, an extra monthly payment that gives you no benefit. If your mortgage is now 80 percent or less of your home's value, get rid of PMI. (You may not have to refinance to do this.)
Pull out extra cash. If you have built up significant equity in your house (the current value of your house minus your mortgage balance), you may be able to get a new mortgage loan bigger than your current mortgage.
This frees up extra cash for other expenses such as funding college and paying off high-interest debt. But follow this strategy cautiously because it stretches out your payments and puts your house on the line. If you miss a few credit-card payments, you can usually negotiate; if you can't pay your mortgage,you jeopardize your house.
Change the terms of your mortgage. You may wish to take advantage of lower interest rates to switch from an adjustable-rate to a fixed-rate mortgage, refinance a seven-year balloon mortgage, shorten the term of your mortgage or trade in a jumbo loan for a conventional loan.
How to Make It Work
If you have decided that refinancing makes sense for you, follow these tips to make sure you do it wisely:
1. Shop around for interest rates. The Internet is a good place to comparison-shop. Two good sites are www.homepath.com and www.bankrate.com.
2. Hold the line on closing costs. Some lenders are taking advantage of low interest rates to jack up their closing costs. And beware of cold-callers.
3. Start with the bank that currently holds your mortgage. It may give you a good deal just to keep your business.
4. Avoid paying points. When you refinance, you can deduct only a portion of the points each year, so it's usually not a good deal.
5. Don't try to outsmart the market and wait for interest rates to hit their low point. If the numbers make sense for you, jump in!
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