It is common to see most of the customers go for refinancing a mortgage after a couple of years of taking it. However, refinancing a mortgage has both its benefits and its pitfalls. It can cause severe hardship and even lead to foreclosures in worst case scenario if done for the wrong reasons and without due financial calculation.
The common scenario for which refinancing is done are:
Lower the interest rate: This is the most common reason for refinancing a mortgage. During periods of continuous interest rate decline, it is preferable to switch to lower interest rates if one has fixed mortgage. It is said that in order to cover closing costs and other fees the interest rate benefit should be at least 1%. However, many financial experts have commented that the ideal range should be 1.5% to 2% interest advantage to refinance. With the prevailing low-interest rates, which are hovering around 4%, it seems that further refinancing would not be possible. For those currently paying an interest rate of 5% or higher they can switch to lower interest rates thus saving tens of thousands of dollars in overall interest expense.
Scenario: In 2009, a couple took a 30 year fixed mortgage of $200,000 at 5.7%. In 2014 after paying a monthly payment of $1,160 for past five years they wish to take advantage of the lower interest rate. The current interest rate is 4.2%.
| Old Mortgage | New Mortgage | |
| Interest Rate | 5.7% | 4.2% |
| Monthly payment | $1,160 | $1,002 |
| Monthly savings | – | $158 |
| Interest expense saving(Total) | – | $47,270 |
They will have to fork out $4,000 towards the closing cost. It will take another 25.3 months to get back the amount they have invested in refinancing.
Shorten the term of the loan: The fifteen-year mortgage is available at a much lower interest rate than the 30 year fixed mortgage. Many buyers end up refinancing to shorten their payment period. This is generally done after a couple of years of purchase. If the purchase is made by a couple in their late 20s or early 30s, they would like to have a low monthly payment. However in a few years with a higher household income they can shift to shorter payment period thus getting the benefit of lower interest rate, shorter time frame and also lesser interest expense.
Figure: Comparison of 15 year and 30-year mortgage rates
It can be clearly seen that the interest rates of 15-year mortgage have a consistent benefit of around 0.75% over the 30-year mortgage.
Scenario: A couple has taken a 30 year fixed mortgage of $200,000 at 4.5%. After five years, they wish to convert the loan to a 15 year loan. For this scenario, we suppose that the interest rate is same after five years. It is 4.5% for a 30 year fixed interest and 3.75% for a 15 year fixed mortgage.
| Old Mortgage(30 year fixed) | New Mortgage(15 year fixed) | |
| Interest Rate | 4.5% | 3.75% |
| Monthly payment | $1,013 | $1,338 |
| Monthly additional expense | – | $325 |
| Interest expense saving(Total) | – | $63,044 |
By paying an extra $325/month, they can reduce their term period by ten years. Ideally couples take this route when they are comfortable with their current budget and want to reduce their total interest expense. In the given scenario, the interest payment will reduce by an astounding $63,044 for the entire mortgage.
If we take a scenario where there is also a falling interest rate environment like we have seen in the past six years, there can be a genuine benefit in switching to a 15-year mortgage. Taking the above example, if the couple purchased a $200,000 house in 2009 taking a 30 year fixed mortgage it would have required a 5.7%. Currently, the interest rate for a 15 year fixed term is 3.2%. For this specific case if the couple refinanced the mortgage it would have the following financial calculation:
| Old Mortgage(30 year fixed mortgage) taken in 2009 | New Mortgage(15 year fixed mortgage) taken in 2014 | |
| Interest Rate | 5.7% | 3.2% |
| Monthly payment | $1,160 | $1,302 |
| Monthly additional expense | – | $142 |
| Interest expense saving(Total) | – | $113,559 |
This new mortgage would require an additional payment of $142/month. The interest expense would be reduced by $113,559, and the term period would be reduced by ten years. Hence when mixed with a falling interest rate environment and shifting to a shorter term period a household can have a huge benefit at the expense of having a small additional payment.
Lower the monthly payment: Another major reason to refinance is to lower the payment made every month. After the extreme situation which people were put in the financial recession of 2008 it made sense to have lower mortgage payment. Refinancing was very beneficial for households that had reduced income during the recession. Generally the payment period was increased which helped in reducing the monthly payments.
Scenario: A couple purchased a house 15 years back taking a 30 year fixed mortgage at 4.5%. They have made regular payments of $1,013 every month. Due to unforeseen circumstances they have to tighten their budget severely. They wish to refinance this loan and make it to into a new 30 year fixed mortgage loan. For sake of comparison, we take the current interest rate as 4.5% also. Let us look at the financial calculations involved in this:
| Old Mortgage (30 year fixed mortgage at 4.5%) | New Mortgage(30 year fixed mortgage at 4.5% started again) | |
| Interest Rate | 4.5% | 4.5% |
| Monthly payment | $1,013 | $568 |
| Monthly savings | – | $445 |
| Interest expense saving(Total) | – | -21,955 |
This refinancing will give them savings of $445/month or $5340 per year. This is a huge reduction for any household. They can take this lean period to mend their finances. Although the period is increased by 15 years, they can try and pay the mortgage earlier, once their financial situation gets back to normal.
Hence, refinancing can be a great tool to aid any household during difficult circumstance. The additional interest expense is a mere $21,955. The overall payment for the old mortgage is $1013*360 = $364680, giving an interest expense of $164,680. Hence, the additional interest expense is a mere 13.3% extra interest expense.
Refinance from an adjustable rate to fixed rate mortgage: During periods of very low interest rate environments it becomes very popular to shift from ARM to fixed mortgage. Although fixed rate mortgage require a marginally higher interest rate than ARM, the household is shielded from any future interest rate hikes. During the current interest rates which are historically at their lowest many households are shifting to a fixed rate mortgage for this purpose.
Refinance from fixed rate to adjustable rate mortgage: This refinancing is popular during a decreasing interest rate environment.
Figure: Comparison of 30, 15 year Fixed mortgage and five, one year ARM
It can be seen that there was a continuous decrease of interest rates in the past three decades. During such a time, it would have been better for buyers to go with an ARM to make sure they are not locked in a higher interest rate by taking fixed rate mortgage. Also, it is better to go for ARM than to refinance every few years when interest rates fall as the closing cost for refinancing is quite high.
Cash out home equity: Many owners use refinancing as a tool to cash out the home equity they have built in the house. Sometimes it is done to extricate oneself out of difficult situations. It is also used as an alternative when investing in other property or starting a business. Needless to say that this option needs to be used very sparingly and after heavy consideration of the pitfalls involved. It can lead a household to go back to the starting point when they have already put many years into building equity in the house.
Figure: Refinancing taken by households in comparison to the existing fixed rate mortgage
Refinancing of mortgage is a major decision for any household and depends on the market conditions and the financial situation of the household. Any step in this area should be taken after good amount of research and advice from qualified professionals. Any wrong decision can impact the monthly budget to a great deal and also put a speed bump in the way of building adequate financial wealth for the household.
http://www.federalreserve.gov/pubs/refinancings/
http://www.makinghomeaffordable.gov/programs/lower-rates/Pages/harp.aspx
http://www.whitehouse.gov/refi
http://www.usa.gov/topics/family/homeowners/buyingselling/mortgages/refinance-transfers.shtml
http://www.benefits.va.gov/homeloans/irrrl.asp