February 18, 2020. By John Wolfsberg:
Mortgage rates continue to be at all time lows as the yield on the 10yr US Treasury is driven lower. This is largely attributable to several factors including a lack of inflationary pressures, expectations of a slowing economy and in some cases a flight to quality. That said, many homeowners are refinancing their mortgages, allowing them to reap the benefits of lower monthly payments or reducing the life of the loan. However, with the immense paperwork and the closing costs involved, it is important to know when and why to refinance.
How does a refinance work?
With a refinance, you pay off your current loan with a new loan. The process can also allow you to restructure the mortgage to fit your needs and current financial plan. Homeowners can choose to refinance for many reasons:
- Shorten your loan’s term
- Refinance to a lower interest rate which will lower your monthly payments
- Convert your adjustable-rate mortgage (ARM) to a fixed-rate loan which will keep your payments safe from possible interest rate increases and higher payments in the future
- Combine a first and second lien to a single loan for simplicity and savings
- Turn your home equity into cash to use for payment on higher interest debts, such as student loans or credit cards.
Despite lower rates, however, it may not always be advantageous to refinance. If you have been paying into your mortgage for 10-15 years (approximately one-third to one-half of the way through the life of the loan) you should review the impact of refinancing with your advisor and dig deeper into the numbers. You may have a stated rate of say 4.5%, however most of this interest is paid in the earlier years of the loan. That said, in the middle to latter years of the loan, you are already effectively paying a lower rate, nullifying the need for restructuring the mortgage.
Refinancing to a lower rate makes the most sense for those operating within the first third of the life of their mortgage. For these folks, it is important to not only consider interest rates, but the many structures offered as well. Various mortgage structures are available, with brokers offering 15, 20, and 30-year fixed rates and adjustable rate mortgages, as well as cash-out refinancing. Look at what fits your situation and what will give you the most flexibility if your financial situation changes. Many feel interest rates are more likely to move higher vs. much lower, so locking in a fixed rate may be wise. Fairway Independent Mortgage offers the following benefits of each structure:
Cash-Out Refinance*: A cash-out refinance allows you to take cash out of your home equity by replacing your current mortgage with a new loan that is more than the amount owed. This option can help you pay for major expenses like college tuition, debt or home improvements. *Appraised property value may affect loan amount.
Adjustable-Rate Mortgage (ARM): Typically adjustable-rate mortgages offer low introductory rates and payments that can change periodically after the initial fixed-rate period. An ARM could be the right choice for you if you plan on staying in your home for just a few years, you’re expecting a future pay increase, or the current interest rate on a fixed-rate mortgage is too high.
Fixed-Rate Mortgage: Fixed-rate mortgages protect you against rising rates since the interest rate remains the same for the entire term of the loan. You can select a 30-, 20- or 15-year term, but keep in mind lower term options have higher monthly payments which means you are building home equity faster. If you plan on staying in your home for a longer time frame, a fixed-rate mortgage could be the right solution for you.
A 30-year fixed rate mortgage is a popular structure as it provides the most flexibility. Your monthly payment will be lowered, but you can still always pay more without penalty if your budget allows. In this structure, it is prudent to try and make the same payment you have been making all along. For example: if you have 27 years remaining on your existing mortgage, and you refinance into a new 30-year product, the clock resets to 30 years again. However, if you make the same previous payment amount but at the new interest rate, more of your payment is going toward principal, and your new 30-year term may be shortened up with the debt being paid off in say 24 years, depending on the new interest rate.
If you do move forward, be aware of closing costs, as well as other costs such as escrows, that will come up during the refinancing process. Your first mortgage payment under the new structure won’t be due until the first of the second month following your month of closing (i.e. if you closer February 15, 2020 your first payment will be due April 1,2020), so the closing costs may not seem as harsh when considering the absorption of the mortgage payment. These costs should also be a point of discussion with your advisor who is able to calculate your overall savings considering all expenses and financial goals.