The interest rate on your mortgage is tied directly to how much you pay on your mortgage each month–lower rates usually mean lower payments. You may be able to get a lower rate because of changes in the market conditions or because your credit score has improved. A lower interest rate also may allow you to build equity in your home more quickly.
For example, compare the monthly payments (for principal and interest) on a 30-year fixed-rate loan of $200,000 at 5.5% and 6.0%.
Increase the term of your mortgage: You may want a mortgage with a longer term to reduce the amount that you pay each month. However, this will also increase the length of time you will make mortgage payments and the total amount that you end up paying toward interest.
Decrease the term of your mortgage: Shorter-term mortgages–for example, a 15-year mortgage instead of a 30-year mortgage–generally have lower interest rates. Plus, you pay off your loan sooner, further reducing your total interest costs. The trade-off is that your monthly payments usually are higher because you are paying more of the principal each month.
For example, compare the total interest costs for a fixed-rate loan of $200,000 at 6% for 30 years with a fixed-rate loan at 5.5% for 15 years.
Tip: Refinancing is not the only way to decrease the term of your mortgage. By paying a little extra on principal each month, you will pay off the loan sooner and reduce the term of your loan. For example, adding $50 each month to your principal payment on the 30-year loan above reduces the term by 3 years and saves you more than $27,000 in interest costs.
If you have an adjustable-rate mortgage, or ARM, your monthly payments will change as the interest rate changes. With this kind of mortgage, your payments could increase or decrease.
You may find yourself uncomfortable with the prospect that your mortgage payments could go up. In this case, you may want to consider switching to a fixed-rate mortgage to give yourself some peace of mind by having a steady interest rate and monthly payment. You also might prefer a fixed-rate mortgage if you think interest rates will be increasing in the future.
Tip: If your monthly payment on a fixed-rate loan includes escrow amounts for taxes and insurance, your payment each month could change over time due to changes in property taxes, insurance, or community association fees.
If you currently have an ARM, will the next interest rate adjustment increase your monthly payments substantially? You may choose to refinance to get another ARM with better terms. For example, the new loan may start out at a lower interest rate. Or the new loan may offer smaller interest rate adjustments or lower payment caps, which means that the interest rate cannot exceed a certain amount.
Tip: If you are refinancing from one ARM to another, check the initial rate and the fully-indexed rate. Also ask about the rate adjustments you might face over the term of the loan.
Home equity is the dollar-value difference between the balance you owe on your mortgage and the value of your property. When you refinance for an amount greater than what you owe on your home, you can receive the difference in a cash payment (this is called a cash-out refinancing). You might choose to do this, for example, if you need cash to make home improvements or pay for a child’s education.
Remember, though, that when you take out equity, you own less of your home. It will take time to build your equity back up. This means that if you need to sell your home, you will not put as much money in your pocket after the sale.
If you are considering a cash-out refinancing, think about other alternatives as well. You could shop for a home equity loan or home equity line of credit instead. Compare a home equity loan with a cash-out refinancing to see which is a better deal for you.
Tip: Many financial advisers caution against cash-out refinancing to pay down unsecured debt (such as credit cards) or short-term secured debt (such as car loans). You may want to talk with a trusted financial adviser before you choose cash-out refinancing as a debt-consolidation plan.
The amortization chart shows that the proportion of your payment that is credited to the principal of your loan increases each year, while the proportion credited to the interest decreases each year. In the later years of your mortgage, more of your payment applies to principal and helps build equity. By refinancing late in your mortgage, you will restart the amortisation process, and most of your monthly payment will be credited to paying interest again and not to building equity.
A prepayment penalty is a fee that lenders might charge if you pay off your mortgage loan early, including for refinancing. If you are refinancing with the same lender, ask whether the prepayment penalty can be waived. You should carefully consider the costs of any prepayment penalty against the savings you expect to gain from refinancing. Paying a prepayment penalty will increase the time it will take to break even, when you account for the costs of the refinance and the monthly savings you expect to gain.
The monthly savings gained from lower monthly payments may not exceed the costs of refinancing. a break-even calculation will help you determine whether it is worthwhile to refinance, if you are planning to move in the near future.