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Mortgage Refinance

A mortgage refinance can result in substantial savings or may not aid a homeowner's budget at all.

The decision to refinance a mortgage can be a complicated one. [©Jupiter Images, 2010]
©Jupiter Images, 2010
The decision to refinance a mortgage can be a complicated one.

Mortgage Refinance

Mortgage refinance options must be carefully considered by homeowners before deciding whether refinancing is appropriate. In addition to considering common things, such as interest rate, length of the loan and whether additional funds will be needed, potential borrowers should be aware of their own credit worthiness, financial situations and the potential disadvantages of refinancing. Understanding when, why and how to refinance can allow homeowners to have more financial flexibility.

What is a Mortgage Refinance?

According to MortgageFit, a mortgage refinance gives homeowners a chance to replace their existing home loans with new loans under different terms. Ideally, these terms would be more beneficial to the homeowner, and may or may not allow the owner to borrow against existing equity in their home. Homeowners who have existing equity owe less on their current mortgages than the amounts their houses are worth. For example, an individual who owns a home worth $200,000 and only owes $160,000 on their mortgage has $40,000 in equity, or 20%. Most candidates for a refinance will have at least 20% equity in their homes.

Advantages of a Mortgage Refinance

There are several reasons why homeowners may benefit from a refinance. An obvious benefit is a lower interest rate. If the homeowner is paying 6.5% interest on their home loan in the above example, they could be paying as much as $1264 per month in principal and interest payments on their loan. By committing to a mortgage refinance at 5.0%, the homeowner can lower their payments to around $1073 per month, which is a significant monthly savings of $191.

A second reason that people might choose to refinance is to escape from an adjustable rate mortgage (ARM). An adjustable rate mortgage can change with the changing interest rate. Often, ARMs are offered to individuals who want a lower rate to begin with and assume they will sell their property within a short period of time (between three and seven years). Homeowners who do not sell their property could then be faced with a much higher monthly payment as their interest rate increases.

Other reasons to refinance include the desire to borrow against the equity existing in the home, to consolidate bills or other credit card debt or to pay down the mortgage more quickly.

When Not to Refinance

In some circumstances it does not make sense for a homeowner to consider a mortgage refinance. For example, if current interest rates are higher than the rate the homeowner is paying, it may not be a good time to refinance.

Sometimes, there is a significant penalty for the borrower to pay off the original mortgage. These charges, along with other expenses incurred when acquiring a new mortgage, may end up costing the homeowner more than the total cost of their initial loan.

If the homeowner has been in the home, paying the original mortgage for a long period of time, such as 10 to 20 years on a 30 year loan, it may not make sense to refinance, since they are effectively extending their debt an additional 30 years.

Timing a Mortgage Refinance

Timing is critical in extracting the most value from a mortgage refinance. Recent mortgage issues have highlighted dropping interest rates, as well as a climb in foreclosures and mortgage defaults. According to TheStreet, even refinance fees have increased to cover some of the recent bank losses. It is also important to consider the time of year a refinance will occur. For borrowers who keep their taxes and insurance in an escrow account, the refinancing bank will often require many months of pre-paid taxes and insurance to be held in escrow. This could add to the overall cost of the refinance, especially if taxes or insurance bills are due around the same time as the closing date. Most mortgage companies insist on keeping several months of buffer for taxes and insurance, and if a large tax bill is due at the same time as the refinance, the buffer will be gone. In this case, the mortgage company will require additional months of funds to be held in escrow.

Borrowers should also be aware of their credit worthiness to ensure they receive the best interest rate available. It might be beneficial for borrowers to spend several months improving their credit scores before attempting a mortgage refinance. As months go by, the borrower will continue to add equity to their home, requiring less money from the new loan. A lower starting principal balance will also lower the monthly payment, and shorten the time it takes the borrower to complete the loan obligations.

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