The rush to refinance mortgages comes in waves, as homeowners keep an eye on interest rates and try to take advantage of market fluctuations to improve their cash flow. In today’s real estate market, with stabilizing or dropping home values and a flood of foreclosures, many homeowners worry about whether refinancing is advisable or even possible.
Financial advisers and lenders say that deciding to refinance a mortgage loan should always be based on individual circumstances, weighing a variety of influential factors. Consumers and their lenders can spend time working on the equation that reveals not only an immediate change in monthly cash flow, but also the long-term financial implications of refinancing.
Michael Rebibo, a certified financial planner with 1st Portfolio Inc. in Vienna, says, “Refinancing can be good for homeowners if they can save money, but they need to understand that saving money is not just about current cash flow. Some people pile on additional debt when they refinance, and they haven’t actually saved anything.”
Mr. Rebibo says that the most important reason for homeowners to refinance now would be to move from an adjustable-rate loan to a fixed-rate loan, which he believes is the smart thing to do.
“It’s a risky bet to think that interest rates will come down further,” says Mr. Rebibo.
Mr. Rebibo says one of the considerations for consumers when choosing to refinance includes the amount of their current loan in relation to the current value of the home. In some areas, home values have dropped, so those homeowners have far less equity than they may have had a year or two ago.
“Lenders are much stricter than they were in the past, so usually in order to refinance you need to have at least an 80 percent loan to value,” says Mr. Rebibo.
Another consideration which influences a refinancing decision is the estimation by the homeowners of how long they intend to stay in the home.
“If you plan to stay in your home for a few years, it makes more sense to refinance than if you are only staying one more year,” says Rick Eul, assistant vice president and mortgage account executive with Bank of America in Annandale. “The problem is, most people don’t really know for certain how long they will stay in one home.”
Mr. Eul says consumers with adjustable-rate mortgages should be evaluating the merits of refinancing into a fixed-rate loan.
“I’ve had a lot of feelers from people with adjustable-rate loans, but some of them are rolling the dice and betting that long-term interest rates will go down,” says Mr. Eul. “People are weighing the closing costs of $2,000 or so versus keeping their current low interest rate and deciding there is no rush to jump into a fixed-rate loan.”
Mr. Eul says that some of the consumers who could benefit from refinancing are unable to qualify for a new loan because they do not have enough equity in their property.
“People with these one-month adjustable-rate mortgages (ARMs), interest-only, pick-your-own-payment kind of deals really should refinance, because they are often seeing negative amortization tacked onto the end of the loan,” says Mr. Eul.
A general rule of thumb for refinancing has often been for consumers to opt for a new mortgage when the interest rate drops at least 2 percentage points below their current loan. In today’s market, however, many consumers refinance for much less of a difference.
“I have some clients who will refinance in order to get from a 6.25 interest rate to a 6.00 interest rate,” says Steve Cohen, a personal mortgage consultant with National City Mortgage Co. in Wheaton.
Mr. Cohen’s financial institution services their own loans, so they are able to refinance existing customer’s loans at little or no cost.
“Closing costs typically run about $1,500 to $2,000 on a refinance, so consumers need to factor that in when they think about whether to refinance,” says Mr. Cohen.
Mr. Rebibo points out that one reason the “2 percentage points difference” rule is less relevant is that mortgage loans are much larger than in the past.
“A one-half percentage point interest rate drop just doesn’t have the same significance on a $100,000 mortgage as it does on a $500,000 loan,” says Mr. Rebibo. “As long as you are staying in the house at least two or three years, a refinance for even that small a percentage change could be worth it.”
Mr. Cohen says that borrowers with adjustable-rate loans, some of which have interest rates as low as 4.75 percent and have interest-only payments, could see their payments jump by as much as $500 per month if they opted to refinance into a fixed-rate loan at 6 percent.
“Even if they know they should switch to a fixed-rate loan, it is emotionally hard to pull the trigger and switch to that higher rate,” says Mr. Cohen. “But if you plan to be in your home longer than one year or so, I do recommend that people switch to a fixed-rate loan.”
Mr. Cohen says that about one-third of the borrowers who call him do opt to shift from an adjustable-rate loan to a fixed-rate loan, but he says that about two-thirds feel they cannot pay the additional monthly payment.
“They are taking a big risk in waiting,” says Mr. Cohen. “I always advise people conservatively and tell them that mortgage rates can get worse.”
Mr. Rebibo says that while some ARMs only adjust every 10 years, borrowers with an ARM expected to adjust within two years should do the math to evaluate the potential benefit of a fixed-rate loan.
“If a fixed-rate loan has monthly payments that are too high, some borrowers could go into a new ARM which adjusts in three or five years,” says Mr. Rebibo. “That might help with their current cash flow and delays a bigger payment increase.”
Mr. Cohen suggests that everyone considering refinancing speak with a financial planner or accountant to evaluate the long-term consequences of changing loan products and looking at the decision in terms of an overall financial and investment picture.
A few years ago when home prices were rapidly increasing, many consumers opted to refinance and take cash out of their home for other purposes. Mr. Cohen says this is much less common today.
“Usually only people with a 50 percent loan-to-value in their home tend to take cash out now,” says Mr. Cohen.
Mr. Eul says that a few customers are still taking out cash when they refinance, but that for the most part, people are not doing it because the money is just not there.
“A cash-out refinance can be a good thing if the homeowners are using the money to reduce high interest rate debt or for home improvements,” says Mr. Rebibo. “But home equity should never be used for consumable items like vacations and cars.”
Mr. Rebibo says that consumers should shop around when they are looking into refinancing. He recommends that borrowers talk with their lender every year or two to discuss the possible loan options and compare costs, interest savings and cash flow.
Mr. Rebibo suggests that consumers consider the benefits of switching to a 15-year mortgage if they can manage higher monthly payments.
“I realize that a lot of people cannot afford this, particularly in this economy, but some people are willing to shift to a 15-year loan,” says Mr. Rebibo. “A 15-year loan is a form of forced savings, and the interest-rate savings is nearly .5 percent compared with a 30-year loan.”
Mr. Rebibo estimates that on a $500,000 loan, a 30-year fixed-rate loan of 6 percent would have a monthly principal-and-interest payment of $3,078. A 15-year fixed-rate loan at 5 7/8 percent would have a monthly principal-and-interest payment of $4,185.
“This additional $1,107, or a 36 percent increase in the monthly payment, represents a huge savings in interest on the home,” says Mr. Rebibo. “But the decision to change to a 15-year loan depends a lot on individual circumstances. If you are in your twenties and in a new job, you might prefer keeping the extra $1,000 per month, but if you are in your fifties and think you will retire in this house, you need to evaluate whether to put that $1,000 each month into the house or into the market.”
Many homeowners in the past five to 10 years opted to finance a home purchase with a first and second mortgage, with the second mortgage usually carrying a significantly higher interest rate. Mr. Rebibo says that borrowers would be wise to refinance their homes and wrap the second mortgage into the first one if they can, but he says it is rarely an option.
“Most of the borrowers who have two mortgages do not have enough equity in their home to refinance both loans together,” says Mr. Rebibo. “The best option if they have the extra cash is to pay down the second loan as quickly as possible, since that loan carries the higher interest rate.”
Consumers have a variety of reasons for refinancing, including shifting into a fixed-rate loan, reducing their monthly payments with a lower interest rate, or consolidating debt into one loan. Evaluating their entire financial picture, rather than looking just at the short-term cash flow implications of a new loan, should be part of the equation to make an informed decision.
REFINANCING TIPS
Know your loan. Dig out that promissory note you got when you first took out your mortgage. That will tell you the type of loan you have, when your rate lock expires and how much your interest rate is allowed to go up per year.
Figure out the costs. Refinancing, in reality, is taking out a new loan. It’s important to find out what other costs you may incur in the process. You may have to pay an appraisal fee or an origination fee that could drive up the overall cost of the transaction. If you are paying $2,500 in closing costs but only lowering your monthly payment $100 per month, it would take almost two years to make up the cost of refinancing.
Work with your lender. Your banker knows your financial history and is a valuable asset in refinancing your loan. They can help you find the best product for your individual situation.
Keep an eye on the market. A general rule to measure whether refinancing is a good idea for you is if the current interest rate on your mortgage is 2 percentage points higher than the prevailing market rate.
Use your equity wisely. Don’t treat your home like an ATM. It takes time to build up equity, and having it is a valuable asset. Refinancing your home to take a vacation is not the best use, but refinancing to get out of a higher interest rate or to pay for your child’s college education may be. Talk with your banker to discuss your individual situation.
SOURCE: AMERICAN BANKERS ASSOCIATION (www.aba.com)
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