When Should You Refinance Your Mortgage
Simply put, you should refinance your mortgage when it will save you money. Don't overcomplicate mortgages by imagining that they're big and scary.
If you can pull together some paperwork (typically: W2, bank statements, pay stubs, tax returns, evidence of insurance), you could be able to save yourself thousands of dollars over the life of your mortgage with a refinance.
Anyone who tells you they know where interest rates will be in a few years is lying to you. The strategy that I recommend to my clients is that they take any refinance opportunity that will reduce their interest rate on a "no-cost loan."
But what is a "no-cost loan"? Doesn't there have to be a catch?
Well, you're right if you assume that your lender and your broker are still making money on a no-cost loan. However, that doesn't mean that it's a bad deal for you!
A general misconception of no-cost loans is that there will be no money due at closing on a no-cost loan. While that makes some intuitive sense, that's a bad way to evaluate the mortgage from the perspective of being the borrower because it's a more complicated transaction than that.
Where Does Money Go in a No-Cost Loan?
I'm going to use some typical numbers to illustrate where the money flows in a no-cost mortgage that should help you understand a refinance transaction.
Let's say your house is valued at $250,000 and you still owe $200,000 on it. Your current mortgage rate is 5%. You have been offered a no-cost refinance at 4% (you should ALWAYS take it, and I'll explain why in the next section).
The costs associated with the loan may look something like the following (it varies by state and by vendor):
- Title Insurance: $700
- Appraisal: $500
- Underwriting Fee: $900
- Closing Fee: $300
- Credit Report Fee: $50
Those costs still have to get paid in a no-cost loan, even if you don't pay them. Here's how that happens.
The lender offers what's called a "lender credit" to cover the costs of doing the loan. When a mortgage loan officer looks at what they call a "rate sheet", on a no-cost loan they will look for a lender credit that covers the costs. In the above example, that would be $2450. On a $200k loan, that equals 1.225% of the total loan amount.
So on the rate sheet, the 4% interest rate may have a lender credit of 1.3% next to it. To understand this a little better, remember that at an interest rate of 3.75%, the lender credit may be something like 0.2%. There would be an option to "pay points" as well if you wanted to pay extra money to get down to a rate somewhere closer to 3% in this example.
You may be wondering why you still have to bring money to the closing table if it's a no-cost loan. The answer is because you still have interest to pay on the old mortgage and you'll likely need to establish a new escrow account (where your taxes and insurance money goes for the next year). I tell my clients that this is typically a wash because you'll get an escrow check refund from your old lender a couple weeks after closing and you'll get to skip a mortgage payment (mortgages are paid after the interest is accrued, or "in arrears", so if you close on October 23rd, you pay for October 23 to October 31 at closing, and your first payment on the new mortgage isn't until December 1).
Why Should I Refinance My Mortgage If There's No Cost?
If there is no cost and the rate is lower than your current rate, you should always refinance your mortgage.
The simple reason is clear if you think about it like this: It doesn't matter how much your lender asks you to pay every month. What matters is your balance and your rate. If you reduce your rate and keep paying the amount you paid on your previous mortgage, you will pay it off sooner. Period.
There's no magic to this, and I think a lot of people get confused by the term of a mortgage. The truth is that a mortgage is nothing more than a balance that is due at a certain interest rate. The term is the longest duration you're given to pay, but unless there's a prepayment penalty (very rare these days), you can pay your lender whatever you want to pay.
Do you agree with my recommendation for when you should refinance your mortgage? Do you have questions? Feel free to ask in the comments below.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2017 Dominic Joseph