Anyone who borrowed money for real estate this year may want to frame their interest rate on the wall. To boost the economy, the Federal Reserve has taken steps that have dropped rates on 30-year-fixed loans from about 6.5 percent four years ago to today’s historic lows of around 3.4 percent. Millions of people who can borrow are jumping at the chance, taking out new home loans and refinancing existing mortgages.
Banks are struggling to keep up with demand—it takes the biggest lenders an average of more than 70 days to finish a refinance, according to a story in the Wall Street Journal. But the long wait hasn’t deterred many homeowners—in the last week of September, the number of refinance applications hit its highest level in three years, according to the Mortgage Bankers Association.
Money management and real estate experts agree that for many homeowners, refinancing now is a great idea, but there are risks to consider. A borrower’s job prospects, the age of their current mortgage, and their credit situation all affect whether getting new loan terms makes sense.
Here are the benefits and costs of replacing your current loan now:
Upsides
1. Cheap loans. The historically low interest rates are the best reason to refinance now, says Andrew Schrage of Money Crashers, a personal finance site. Today’s numbers for 30-year fixed-rate loans are lower than the 1-year introductory rates on adjustable rate mortgages in most years since 1992. And 15-year fixed-rate loans are dipping under 3 percent. With today’s rates about 1 percent lower than the already rock-bottom rates of 18 months ago, someone who borrows $100,000 will save themselves more than $20,000 in interest over the life of a 30-year fixed-rate loan, compared with the same loan taken out in March 2011.
2. Improved loan period. In addition to lowering your rate, consider shortening the length of your loan. In the first years of a 30-year loan, you’re paying almost all interest—it’s not until the later years that you start paying principal. With rates this low, you can often both lower your monthly payment and shorten the length of your loan, saving thousands in interest, says Stuart Feldstein of SMR Research Corporation, which does market research on the home mortgage business.
But there’s an opposite school of thought on how to use a refi. Ric Edelman, founder of one of the country’s biggest wealth advisory firms, recommends refinancing into another 30-year fixed (or from a 15- to a 30-year) and using the savings on your payments for other investments that will generate higher returns. He adds that a longer mortgage term also nets you a bigger annual tax deduction—at least for now—than if you shorten the term.
3. More options. Be sure to shop around—the gap between the best and worst deals can be as much as a full percentage point, according to the Wall Street Journal. Elizabeth Weintraub, a San Diego-based realtor who covers refinancing issues for About.com, says consumers should go local when possible: “That face-to-face with somebody that you’ve actually met, it makes a difference versus somebody you’re talking to on the phone….” Borrowers looking to refinance also aren’t under as much pressure as new home buyers, she says. “When you do a refinance, you have the luxury of time to really investigate your options…. Because you can walk away from a refinance. You don’t have to close that loan.”
4. More leverage. Since so many loan providers are offering low rates right now, you’ll have more negotiating power to get a better deal. Federal law requires lenders to give you an estimate of what they’ll charge to complete your refi. Weintraub suggests bargaining to eliminate or reduce “garbage fees” that appear on your estimate—things like document preparation, wire transfer, courier, commitment, and rate-lock fees—which can add $800 or more to the cost of the loan. “There’s usually some flexibility there,” she says. She even suggests that if the interest rate falls just before you close on your loan, you should ask the lender to give you the lower prevailing rate. “They’ll say no, you can’t do that, you’ve locked in your rate and you’re stuck,” she says. “But that’s not true… if they find out you’re going to cancel it, all of a sudden that rate comes down.”
5. Escape from adjustable rate mortgages. Refinancing allows people with adjustable rate mortgages (ARMs) to convert to fixed-rate loans, an advantage even if they don’t save on their monthly payment immediately. “If you have an ARM, refinancing to a 30-year fixed can not only lower your rate but dramatically improve the safety of your loan by eliminating the risk that your rate might increase,” says Edelman.
6. Loan mergers. Refinancing lets you consolidate a second mortgage or a home equity loan with your home mortgage, which can save money by allowing you to pay one low rate on the entire amount, instead of a low percentage on your primary mortgage and a higher one on the other loans.
7. Cash in your pocket. If you have equity in your house, a cash-out refinance lets you pull out capital for productive uses, says Schrage. But don’t make the mistake of so many people leading up to the financial crisis—draining equity to pay for vacations or consumer purchases. “I’d only consider it for necessary expenses, such as a home renovation or [paying for] college…” he says.
Downsides
1. Fees. Even if you get rid of junk fees, the cost of refinancing can offset the savings you’ll get on a lower monthly payment under your new loan. Look carefully at the refinancing fees to make sure your savings will pay back those costs in a reasonable timeframe, says Don Martin, an independent financial advisor in Los Altos, California. Typical fees, says the Federal Reserve, range from $1,900 to $3,650, not including any loan origination fee (0 to 1.5 percent of the loan principal), private mortgage insurance (0.5 to 1.5 percent), or loan discount points (0 to 3 percent). Use a refi calculator to determine your break-even point—the number of months it will take you, at your lower payment, to recoup what the lender charges for refinancing your loan. And to figure out when interest rates have fallen low enough to consider refinancing, use this calculator from the National Bureau of Economic Research.
2. Financial risk. Weintraub notes that in some states your initial mortgage is a “non-recourse” loan—if you don’t pay, the bank can foreclose your house and keep the proceeds from a sale but can’t come after your other assets if there’s a remaining deficit. But refinanced mortgage loans are usually “recourse” products—if you default and the sale of your house doesn’t cover your loan amount, the bank can seize other assets. If you’re worried about what happens in your state if you default on a refi, check with the state’s housing finance agency.
3. Few people qualify. Banks are being more selective given the lending problems that caused the housing crash, says Feldstein. People with even average credit scores may start the refinancing process but be rejected or pay a higher rate once banks check their scores. To get the lowest rates being advertised now, you’ll need a score of 720 or above, Chris Boulter, president of loan specialist Val-Chris Investments tells Yahoo Homes.
4. Prepayment penalties. Your original loan may include a penalty for paying it off early, which includes refinancing it. (The Truth in Lending statement for the loan should include information on whether it has a penalty.) You should include the costs of any penalty in calculating the time it will take you to break even on the refi. If you’re refinancing with the same lender, try asking whether that penalty can be waived.
5. Less mobility. If you refinance, you’ll have to stay in your house for at least a few years to recoup the fees you paid to get the lower monthly rate. Otherwise, says Schrage, you’ll lose money on the deal. For example, on a refinance of $100,000 in which you drop your interest rate by 2 percentage points and pay $3,800 in fees, it would take about 32 months to break even.
6. Little savings for recent refinancers. Today’s rock-bottom mortgage rates were only about 1.5 percentage points higher this time two years ago. Many people have already refinanced since then and won’t save much by doing so again now. Feldstein says refinancing “may not be such a hot idea” if you’re not going to drop your interest rate by at least a point and a half.
7. Paperwork, paperwork. You have to suffer a little to get that lower rate. At a minimum, that means completing a lengthy loan application that allows for a complete review of your finances and employment history, including providing recent income tax returns, pay stubs, investment and loan statements, and proof of checking and savings account balances. You’ll also need to work with the loan officer to get a survey and appraisal completed, provide proof of homeowner’s insurance, and sign off on a blizzard of documents at settlement. “The loan qualification process is more onerous than ever because of the credit crisis five years ago,” says Edelman. So if you pursue a refi, he says, you’re in for “an annoying couple of months.”
