Mortgage rates are flirting with historic lows again, and you may be thinking that now is the time to refinance. If you decide to move forward to reduce your rate, you should keep some facts in mind. Having a little knowledge as you proceed can turn your refinance into a powerful lever to improve your financial picture.
We’ll explain how the refinance works and then give you the information you need to get the most mileage out of a refinance.
How much will you save, really?
There are many on-line calculators to tell you how much money you’ll save if you refinance. They will ask you for a lot of personal information, then tell you how much you’ll lower your payment. That number, by itself, can be misleading.
To get a sense of the bigger picture surrounding your refinance, you’ll really want to know current rates and your home’s value.
If rates are lower than you are currently paying and your home value has increased, it’s time to stop guessing and speak with a mortgage company representative about how you can benefit from refinancing.
When you get a new mortgage to replace your old one, several things will happen. Obviously, you will reduce your monthly payment, but part of that reduction is due to a longer term on the new loan. If you have had your current 30-year mortgage for 6 years, you have a remaining term of 24 years. The longer term of your new loan is part of the reason your payment drops—not just the lower interest rate. This is called “reamortization.”
There’s nothing wrong with extending your loan term, but if you hope to own your home some day with no mortgage, you can simply increase your monthly payment slightly to keep your loan term the same. You’ll still save money because of the lower interest rate, and you’ll be able to stay on the same mortgage payoff schedule you started with when you got your old loan.
Financed closing costs
Your loan balance may go up when you refinance. It is very common and acceptable to add all the closing costs into your new loan to avoid having to come up with cash. If you decide to have an escrow account to have the lender pay your taxes and insurance, you’ll fund the account at the beginning. You will also skip a payment, but the lenders will still charge prorated interest on the money. You can add that money to the new loan as well. It may feel like a free ride, but it really isn’t.
Your old lender will send you a refund for the balance of your old impound account. The amount will vary according to the time of year. It could range anywhere from a couple of hundred to several thousand dollars. Your current mortgage statement may tell you how much money is in your impound account. Whatever the amount, the check from the old lender will feel like money dropping from the sky. In reality, they’re just giving you back your own money.
You can avoid a higher loan balance by applying this “extra” money to your loan’s principal when it arrives. This way, you won’t have to take money out of your pocket at close of escrow, but you will be able to reduce your balance in a couple of weeks, when you get your impound refund.
Applying that additional money to your loan principal will actually shorten the term of your new mortgage. If your new loan is $300,000 and the rate is 3.75%, your monthly payment will be $1,389.35. Paying $2,000 extra to the loan—your impound account refund in this example—will cut your loan term to 356 payments from 360. That’s four months off the term of your loan.
Leveraging the benefits of your new mortgage
Your payment will be lower after the refinance. After all, that was the point, wasn’t it?
You’ve skipped a payment (money in your pocket), gotten a nice impound account refund check from your old lender. What now?
If you’re like most people, nothing will change. All that money will get absorbed into your household budget and you won’t feel any different.
Here are some suggestions to get the most mileage out of your refinance.
- Apply the monthly savings to the principal balance of your new loan. We’ve already seen how easy it is to cut the loan term by applying a small amount to the balance. If you continue making the same payment that you were making on your old loan, you’ll pay off your new loan faster. If your old loan had a rate of 4.5%, a balance of $300,000 and a payment of $1,630, you’ll reduce your payment by $240 if your new loan has a rate of 3.75%. But if you keep making the same payment as before, you will cut your loan term by more than three years.
- Pay off debt. If you are carrying any consumer debt, especially credit card debt, paying it off quickly is one of the best things you can do with your available cash. Paying off debt is actually a form of investment—in fact, it is the only risk-free investment you can make. Applying that “extra” money to expensive consumer debt is a powerful (and painless) financial strategy.
- If you have financed the closing costs into your loan (as most people do), consider making the same payment that you made before the refinance until you have “broken even.” If your closing costs are $3,600 and you have reduced your monthly payment by $300, you will recover those costs in a year. Then, you can drop your monthly payment to the “official” amount.
Refinancing your mortgage can benefit you in many ways: it can free up cash in your household budget, it can shorten the term of your loan, or help you pay off expensive consumer debt.
To explore the benefits for your own unique circumstance, contact a Sammamish loan officer today.