When Should You Refinance?
It might seem odd to think about refinancing soon after you buy your new home. However, the timing of a "refi" is important and it's never too early to consider it. For some owners, this decision is simple -- you refi as soon as you can get a lower monthly payment or if you need to take money out. This, however, can sometimes be unwise. It's better to take a few moments and look at consequences. There are usually three variables to consider:
- Consider refinancing when interest rates drop.
- Consider refinancing when you need the money now.
- Consider refinancing when you can qualify, particularly if you're concerned that you might not be able to qualify for a new mortgage in the future.
1. Are Interest Rates Lower?
A decade ago, before refinancing, owners were always cautioned to observe the "2% rule." This rule stated that interest rates had to drop 2% before it paid to refinance your home to a new lower rate mortgage. The reason was the high transaction costs of refinancing. Today, the 2% rule is out the window because no-cost refis have become readily available and the costs for some refinancing have been reduced dramatically. Further, those costs can often be included in the new loan by accepting a slightly higher interest rate. Thus, today it usually makes sense to refi at any time that you can lower your interest rate and monthly payment without increasing the balance (or dramatically affecting the term) of your mortgage, as long as there are no extra costs.
2. Do You Need the Money?
A separate reason for refinancing revolves around taking money out of your equity in the property. Typical good reasons include using the money to finance an education, home improvement, cover emergency medical or other costs, and in some cases, consolidate long-term debts. The rationale here is that you're putting the money to long-term or emergency usage.
On the other hand, typical bad reasons are to take the money out of the property to purchase a new car, to go on a vacation, or to pay off short-term debt. The rationale for determining good or bad uses for the money usually revolves around the time factor. A mortgage is a long-term debt, typically 15 to 30 years. On the other hand, buying a car, is typically a short-term purchase. In 5 to 7 years, the car might be worn out and you will need another. Yet if you got money to make the purchase from a refi, you'll be paying on that debt for 15 to 30 years, long after the car is in the junkyard.
This, on the other hand, is usually considered a good reason to pull money out of your equity. The reason is that you're actually building more equity in the property. Hopefully a home that has been improved will be worth considerably more than an unimproved house.
There could be some tax advantages to taking money out for home improvement. If you used all or part of the refi money to pay for home improvements (and provided you meet certain eligibility requirements such as the home being your principal residence), then points you paid, if you had a transaction charge, might be deductible in the year paid. (Otherwise, they are capitalized over the entire term of the loan.) Other expenses such as title insurance and escrow charges are not normally deductible on your principal residence.
Is Your Need Immediate?
Sometimes when interest rates fall, there is the urge to refi and pull money out of your home, even if you don't have an immediate need for the money. The idea is that you want to grab onto those great low interest rates. And you can always stick that money in the bank.
Not having an immediate (within six months to a year) use for money pulled out of equity, however, makes little sense. For example, you pull $50,000 in equity out of your home. Now, you might be making payments at 6% on this money while it earns 2% on the bank. You're actually losing 4% of the money to interest payments annually.
3. Can You Qualify?
If you recently purchased and since then interest rates have dropped, chances are that you will easily qualify for a new, lower-rate mortgage. After all, you'll be going for lower mortgage payments than you currently have and, assuming your income and credit haven't changed, getting the new mortgage should be a breeze.
On the other hand, if you recently bought and now want to pull money out of your home, it could be trickier. Pulling money out means getting a bigger loan. And a bigger loan often means higher payments. To find out just where you stand at any given time, contact a mortgage broker and get preapproved. You'll immediately know how big a loan you can get given current interest rates and your present financial condition.
How to Pull Money Out -- The Refinance
The key to being able to refi and pull money out is whether or not your property has gone up in value. For example, if you originally obtained a 100% LTV (loan to value) mortgage and prices haven't moved up, there's no way to pull equity out of your property -- you don't have any equity!
On the other hand, if since you bought the price of your home has gone up 50%, you should have loads of equity you can pull out no matter how big your original mortgage. Usually, before letting you pull equity out, lenders want to see that you have at least 20% equity.
Getting a Second Mortgage
There is another way to refinance that doesn't involve replacing your existing first mortgage with a new one: getting a second mortgage. In this case, you keep your original loan and add another on top of it. This second might have various names such as a "home equity loan," "home improvement loan," or "revolving line of credit."
The advantages of getting a second mortgage are that you do not have to disturb the original first mortgage. For example, perhaps interest rates have gone up since you purchased. Your mortgage carries a 5% interest rate. But new firsts are at 6%. A new second mortgage might be at 7%. Depending on the amount borrowed, it might be cheaper to obtain the higher-interest second, than a new higher interest first.
The way to determine whether it pays to get a new second or a new first is to determine the blended interest rate. For example, if you already have a large first mortgage of $100,000 at 5% and can get a new smaller second mortgage of $50,000 at 7%, the blended rate is roughly 5.5%. This is better than getting a new first mortgage of $150,000 at 6%.
You have to recalculate each time for the amount of the mortgage and the interest rate. Many online lenders (such as eloan.com) have calculators to help you with this. Also, we're assuming your existing first is only a few years old. If it's an older amortized loan, the principle has gone down and there's less interest to be paid.
Disadvantages of a Second Mortgage
There are some disadvantages of getting a second mortgage. Typically the payments will have a shorter term, often 15 years or less. This means that the money payment will be significantly higher than for a longer-term loan at the same interest rate. Further, the interest rate might be significantly higher. Finally, in many cases lenders won't wrap the costs of the refinance into the second, but will want to be paid separately. This can make the loan less attractive.
Variations on a Second Mortgage
Banks will offer a second mortgage or home-equity loan typically in two forms. In the first, you get the money all up-front. In the second you get what is essentially a revolving line-of-credit. You can borrow on your home equity up to certain limits at any time and pay the money back at any time. You are only charged for the time you actually used the money. There is typically an annual charge for this type of account, although the bank will usually absorb any closing costs.
This is a very versatile type of financing and is excellent when used as a source of emergency money. However, only rarely is the interest rate fixed. Usually the interest rate varies depending on market conditions and tends to be significantly higher than for first mortgages.
A home-improvement loan might be nothing more than a home equity loan by a different name. However, some lenders will offer a home improvement loan based on "take as you go." You take out the money as you make your improvements. You only take money out (although typically you only pay interest on the money withdrawn) and once you've taken it out fully, the loan converts to a longer term (typically 5 to 15 year) lower interest rate loan.
A home improvement loan of the above type can sometimes carry a lower interest rate than a revolving home equity loan. It sometimes can also be insured through HUD (see FHA home improvement loans at www.hud.gov)
Adjustable versus Fixed-Rate Mortgage
Finally, there's the matter of getting a mortgage with an interest rate that fluctuates according to market conditions, or is fixed for the life of the loan. The advantage of the adjustable rate mortgage is that it carries a lower initial interest rate (sometimes called the "teaser" rate). However, that rate rises as the market for mortgage interest rates rises.
The general rule is that it pays to lock in low interest rates with a fixed interest rate loan. On the other hand, it pays to get an adjustable rate mortgage when rates are high so that your interest rate will fall as rates generally drift down.
Most adjustable interest rates have "caps," which prevent interest rates from rising above a certain maximum amount. (They also have "steps," which limit how fast and big interest rate jumps can be.) However, these caps are typically set very high, often twice or more the original interest rate. If your loan jumps from 5% to 10% (even if it's done gradually through small steps), your monthly payments are going to skyrocket even with caps.
Excerpted from Tips and Traps for New Home Owners by Robert Irwin. Copyright © 2005 by The McGraw-Hill Companies.
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