Certain questions need to be addressed when determining a strategic approach to refinancing. How long do I expect to live in this home? How long do I expect that I may keep this loan? Does my loan have Private Mortgage Insurance (PMI)1?What is my current Loan to Value?Is the housing market in my area appreciating, and if so, at what rate? What are my thoughts on the future of interest rates, both short term and long term? Is there a major renovation on the horizon for my home? Do I have major expenses upcoming, e.g., marriage of a child, college expenses, etc.? Answers to these questions and possibly more come into play as to how to structure the refinance. Note that with lower interest rates, the question is not ‘should I?’, but ‘how should I?’. These solutions will be determined not only based on the answers to these pertinent questions, but on current market conditions and trends. For example, certain loan programs might offer terms that can be very beneficial vs. a different program not providing those terms.
If you are paying all of your closing costs upfront, it’s important to consider how long it will take to recoup those costs through your monthly savings. This is known as the “break-even point”. Answers to the questions above will have an impact on how you structure your loan and account for closing costs. It is important to note that every new loan has closing costs2 associated with that transaction. A key strategic decision is how those closing costs are paid.If you pay in up front cash or by financing the closing costs into the loan and if you plan to stay in your home beyond the break-even point, refinancing could save you money over the life of your loan.
Depending on the interest rate market conditions, another option for paying the closing costs may be a lender paid premium based on the interest rate. For example, accepting a slightly higher interest rate that involves a cost, choosing an interest rate that offers premium pricing could be an option. In this case, by accepting a higher interest rate and the corresponding higher payments, the lender paid premium may be used to pay all or part of the closing costs.If this new rate is lower than the current rate on the loan to be refinanced, a borrower is guaranteed to save money from day 1, and there is no break-even point. This option may be ideal to address uncertainties regarding future interest rates or the prospect of staying in the home for a specific period of time.
The most common objection to this strategy is that a borrower may be resetting the amortization period beyond the current loan’s projected payoff date (assuming the total amortization period on the new loan is the same as the old loan). The simple mathematical answer to this concern is that if the borrower were to refinance into the lower rate and continue to make the same payment on the new loan as they were on the previous loan, the new loan would pay off sooner than the previous loan is scheduled to, saving the borrower interest expense over the life of the loan. A borrower could also go forward and simply save the cash flow benefits that come from the lower interest rate and corresponding payments on the new loan.
It’s critical to note that resetting the term of the loan and moving the amortization schedule does not necessarily mean that borrowers will pay more over the life of the loan. In fact, by refinancing into a lower interest rate, borrowers could potentially save thousands of dollars in interest payments over time.
It is important to consider all these factors before deciding. Since a refinance involves closing costs, strategically addressing the costs and benefits is a critical step in this decision making process. Working with an experienced professional to address these needs is an important element in making wise decisions.
1 See What is Private Mortgage Insurance? Do I need it and how do I get rid of it?
2 See Closing Costs.
