With mortgage interest rates at all-time lows, there’s a surge of refinance activity as homeowners try to take advantage of the drop. For most homeowners, refinancing at these rates makes abundant sense. But there are costs involved in refinancing your home that homeowners are not always aware of. Some of them are built into the package of the new loan, and aren’t always obvious.
This isn’t to say that you shouldn’t refinance, only that you need to be aware of certain realities so that you can either avoid them, or at least minimize them. Lets take a look at some of the benefits – and risks – of refinancing your home.
The twin focus of most refinances
Most people refinance due to two primary factors: rate and monthly payment. An interest rate dropping from say 6% down to 3.5% is certainly attractive. So is the possibility of saving $200 or $300 per month on your house payment.
Numbers such as these are attractive to homeowners, since they represent measurable benefits from the refinance. But there are certain costs involved in refinancing that have to be considered in light of the savings that are expected to come as a result of getting both a lower interest rate and monthly payment.
Closing costs are the most obvious and easily measurable costs involved in a refinance. Closing costs are presented to the borrower at both the application and the closing, in hard numbers that are easily understood. You can know for example that you are paying $3,000 in closing costs to lower the interest rate on your mortgage from 6% to 3.5% on a $150,000 loan.
One of the most popular ways to determine if the closing costs paid justify doing the refinance is by dividing the amount of the closing costs by the monthly savings. This is sometimes referred to as the “recapture period”. If you divide $3,000 in closing costs, by a $200 per month reduction in your house payment, you will see that the refinance will pay for itself in just 15 months.
Most financial experts will say that if you can recover your closing costs in 24 to 36 months, then the refinance is worth doing. This is especially true if you plan on being in the house for five years or longer. Not only will you recover the closing costs paid within the first two or three years, but you’ll reap a real savings in every year there after.
We don’t normally think of cash out as a closing cost, but taking cash out on a refinance does add to your total indebtedness. This is particularly true if you have done “serial refinances.” Since interest rates have slowly stair-stepped downward over the past 20 years, many homeowners have refinanced several times in that period. If you added just a few thousand dollars to the loan amount each time you refinanced, and you did it five times, you could have increased your loan balance by tens of thousands of dollars.
Cash out refinancing isn’t just about taking out large amounts of money. If each time you refinanced, you added the closing costs to the new loan amount, and took out an extra $2,000 or $3,000 for miscellaneous purposes, you may have added $5,000 or $6,000 to the new mortgage amount each time. If you’ve refinanced in this way five times over the past 20 years, you may have added as much as $30,000 to your original mortgage balance.
This isn’t a cost in the sense that we normally think of as a real expense, but if the goal is ultimately to payoff your mortgage, these mini cash-outs are having the exact opposite effect. That’s a cost in some fashion.
Recasting the original loan term
Once again, this is not commonly seen as a cost, and it doesn’t represent an out-of-pocket expense in the near-term, but it does make the cost of your mortgage higher over time.
If you have a 30 year mortgage that you have been paying on for five years, you have 25 years remaining on the loan. If you refinance, and recast the loan back to 30 years, you may be saving money on the monthly payment, but you are also adding five years of payments to the back end of the loan.
If you have refinanced your home several times over the years, it’s not inconceivable that you could have unknowingly turned your 30 year purchase money mortgage into what is effectively a 50 year loan. By adding a few years to the loan term each time you refinanced, you will have extended your period of indebtedness on the house for a substantial amount of time.
This is a very common practice, and it is also a major reason why house payments drop as much as they do on refinance. The payment on a new 30 year loan will be less than what it was on the original mortgage simply because you are stretching out the repayment period.
In order to avoid this trap, keep your new mortgage term to not more than the remaining term on your existing mortgage. The reduction in your house payment from the refinance should be the result of a lower interest rate, and not an extended mortgage loan term.
Any of these costs can be minimized or eliminated, and by doing so, you will get true savings from doing a refinance.