February 07, 2012

To Refinance or Not to Refinance, That is the Question

Credit: jscreationzs
One of the most common questions I get from clients is whether or not they should refinance an outstanding mortgage. As is the case with most financial advice, it depends. It depends on how much lower the potential rate is than the current rate, it depends on what type of mortgages or lending instruments we are talking about, and it depends on fees and closing costs. Let me quickly walk you through the decision-making process as I would a client.

The first items I would want to know from a client are their current interest rate and the rate of the potential new mortgage. If the difference between the two interest rates is not more than one percent, the conversation will usually stop there. This is because any small monthly payment benefit you might receive from that refinance flyer you got in the mail will most always be immediately negated by administrative fees and closing costs that you must pay. In addition, anyone who has been through a closing knows that the whole process is usually a stressful hassle with a cost in sweat and tears in addition to dollars.

The second items I would want to know from a client are what type of mortgage they are currently in and what type of mortgage they would be potentially refinancing into. Basically I would be checking to make sure the client is not thinking about refinancing into another 30-year mortgage when they are already 10 or 20 years into their current 30-year mortgage. The lower interest rate of the refinanced mortgage would not matter because the overall costs would be increasing due to the longer period of interest rate compounding. In English, 3.5% over 30 years is not necessarily better than 4% over 15 years. I would then take the opportunity to talk to the client about how comfortable they are with increasing their monthly payments. Refinancing into a shorter term mortgage is sometimes more beneficial than even the lower interest rate. This is because a 15-year mortgage roughly requires a monthly payment of only 25% more than a 30-year mortgage and allows you to build up equity in your home twice as fast!

Based on the client’s responses, I would then raise a few other questions such as:

- How is your credit now since the last time you got a mortgage? If it has gotten worse, refinancing probably does not make sense. You’re not going to get as favorable terms as you did the first time!

- How much equity do you have in your home? If you have to borrow more than 80% of the value of your home, you’re not going to be getting the best rates. You should probably wait until you have finally reached that 20% down threshold, and then consider refinancing.

- What are your closing costs? I’ve mentioned this already, but you really do need the specifics before you refinance because many items, such as recording fees, title fees, appraisal fees, attorney fees, points, and transfer taxes, could come into play. These one-time payments alone can make your decision for you about whether or not it is a good idea to refinance.

With interest rates at historical lows over recent years, refinancing has been very popular. Refinancing has been a very good financial strategy and has helped many of my clients, but you can actually make things worse for yourself and cost yourself more money in the long run if you do not consider things carefully.


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