The news is abuzz with the quarter percent interest increase that came from the Federal Reserve back in mid December, causing all sorts of panic and riots in the street. Well, maybe not riots — but a lot of people are wondering if they need to refinance now or if they’ve already missed their opportunity. Many of those same people, when asked why they think they need to refinance, can’t tell you why. They’ve just had the idea beaten into them that having a low interest rate is good and having a high interest rate is bad.
With that in mind, I thought I’d help you figure this refinance thing out, since there’s a good chance you’re either thinking about starting the process or are worried that you waited too long to get the best rate. There are lots of reasons to refinance, but “rates are increasing” should not be one of them unless the Fed suddenly decides to increase the rate by five or 10 percent, which they won’t because they’re as interested in seeing the economy recover as the next guy.
The Parts of Your Mortgage Payment
I’m sure we’ve covered this before in every article where we’ve talked about payments, but when it comes to refinancing, you guys tend to forget that there’s a lot more to how much you’re going to pay besides the interest. So, as a quick review, let’s look at the basic parts of your payment:
- Principal. Everybody has to pay principal, mostly. If you have an interest-only loan, you won’t pay this, but otherwise, the principal you pay reduces your overall debt each and every month. So, for example, if you’re paying $1000 this month in principal, you’re knocking $1000 off your note with this payment. Yay!
- Interest. Think of this as a fee for using the bank’s money — interest is a charge that’s applied each month to your overall debt on top of your principal. It’s based on a percentage of your remaining balance, as specified in your mortgage documents. Currently, that rate is probably between four and 10 percent, depending on when you got your mortgage and how good of a risk you were at the time you took it out.
- Homeowner’s Insurance. Most mortgages require that you keep mortgage insurance on your property, your bank guarantees your compliance by adding about 1/12 of your homeowner’s insurance premium to your payment each month. At the end of the year, they use the money that they’ve held in an escrow account to renew your coverage. The price is risk-based and uses both regional and personal data to determine how likely you are to make a claim.
- Real Estate Taxes. Like with homeowner’s insurance, real estate taxes are usually escrowed and will be taken as 1/12 of the tax burden with each payment. The bank wants to make sure you still own your property at the end of the year, so they’ll make this payment on your behalf as long as you’re allowing them to escrow those little payments. Your municipality will base your taxes on the value of your home.
- Homeowner Association Dues. Sometimes HOA dues are also included in your payment. The pricing of these can vary wildly. You agreed to pay them when you bought your home and, theoretically, you’ve been able to vote on any subsequent increases in the rate.
- Mortgage Insurance. If you bring less than a 20 percent downpayment to closing, your bank will require that you carry mortgage insurance of some type — for conventional loans this is called PMI (private mortgage insurance), FHA loans call it MIP (mortgage insurance premium). VA loans don’t have monthly mortgage insurance payments because the funding fee covers all the mortgage insurance upfront. Your rate will vary, based on your mortgage insurance program and your home’s loan to value ratio. Mortgage insurance rates range from under a half a percent to over one and a half percent of your mortgage value, depending on the program.
Now that we’ve gotten that out of the way, we can discuss when to refinance and when it doesn’t make a lot of sense, like as a knee-jerk reaction to a quarter percent increase in interest rates.
Six Good Reasons to Refinance
If you read the section above outlining the parts of your payment, it should be abundantly obvious that your interest rate isn’t all there is to your payment. Paying less interest doesn’t always help you, especially if it means paying a higher mortgage insurance rate or increasing your principal to cover the closing costs associated with a refinance. However, there are plenty of good reasons to refinance, don’t think there aren’t. Here are six very common and very good reasons to refinance your loan sooner rather than later:
- You’ve been working on your credit file and paying down debt. Maybe you bought a house using a less than ideal loan because you thought you needed to right then. Maybe you inherited a place and needed to get your name on it and assumed a mortgage that wasn’t stellar. Whatever the reason for having a not so awesome loan, you’ve been working on your credit since then and paying down your debts. Today your credit is awesome and your income to debt low — and you think you deserve a loan that matches your commitment. The truth is, you probably do. When you’ve become an ideal candidate for a new loan, not only will your interest rate drop, your mortgage insurance rate may as well. Conventional loans, especially, base your mortgage insurance rate on your credit rating, but they don’t re-evaluate you if your situation improves after the loan is in place. So, good credit today can spell lots of savings down the road.
- You’ve decided that you want to stay in your home long term. If you intend to pay off your current home, you’ll be money ahead to shed any extra costs you can. For example, an FHA loan made before 2001 or after 2013 may have mortgage insurance that can’t be cancelled, no matter your home’s loan to value ratio. This isn’t that big of a deal if you plan to sell in a few years, but if you’re going to make all 30 years worth of payments, you’ll spend a lot more over the lifetime of your FHA loan than you would with a conventional.
- You had a windfall. Most mortgages will allow you to pay a big chunk off any time you want, but they won’t recast your mortgage payment. If you want that inheritance, lottery winning or recently discovered pirate treasure to reflect in your monthly payment, you’ll need to refinance your loan. After paying down a significant portion of your principal, you’ll find yourself with a much smaller and more manageable mortgage payment.
- You’ve finally reached 78 percent equity, or your home has increased in value tremendously. As mentioned above, a number of FHA loans will not allow you to drop your mortgage insurance, even if your home has enough equity that would normally allow other loan programs to do so. There’s only one solution to this kind of mortgage insurance woe — and that’s to refinance. If you’ve made major improvements to your home, your neighborhood has increased in value or you’ve simply paid all your payments until your principal is below 80 percent of your home’s original appraisal, you may be able to refinance into a loan program that will eliminate mortgage insurance and allow you to contribute more of your payment toward your principal.
- You want to refinance your HELOC into your mortgage. Having two mortgage payments can be a lot to keep track of, so many people choose to consolidate their home equity loans into their primary mortgages when they can. Instead of juggling two payments, that money you borrowed to help with an addition to your home or to remodel the kitchen can be combined with your primary mortgage, if you have enough equity. Keep in mind that doing this may create a situation where you’ll be paying mortgage insurance for some amount of time, but the interest savings between the old HELOC and the new mortgage can be significant enough that it’s worth the cost.
- You want to add or remove someone from your mortgage or deed. This is a tricky one. People get married, they get divorced, they develop other sorts of arrangement with other legal entities and often times property is involved. So, let’s say that your parents co-signed your original mortgage and were put on the deed to your home at closing as a lender requirement. Now you’re getting married and your spouse would prefer they be on the deed rather than your parents. In order to make these sorts of sweeping changes, many times your lender will want you to refinance to remove your parents from the debt instrument and add your new spouse. Any time you legally change the deed or the debt-obligated parties, you likely need to refinance and create a new mortgage.
The Bottom Line: There are Many Reasons to Refinance, But Interest Rate Isn’t the Main One
Your interest rate definitely plays a part in determining your final payment, but it should be one of the last factors you consider when trying to decide if it’s time to refinance. After all, there are so many other things that go into determining your payment that a single percent change in your rate often saves you much less than you’ll spend getting the rate reduction.
However, if you’re looking to change loan programs, consolidate your mortgage debt or need to do some legal shuffling, refinancing may save you a great deal of money and headache in the long term. And even then, the greater your outstanding loan tenure, the more money you will save by refinancing into a lower interest rate loan.
When it comes to refinancing, it’s vital that you look at the bigger picture before taking the plunge. After all, refinancing can be costly and if you spend more on closing the new loan than you’ll be saving, you’ve not really gotten ahead at all.