What Does "Refinance" mean?
In case you're not familiar with the term, Refinance (Refi for short) basically means to replace an existing loan with a new loan. The new loan pays off the existing loan, leaving with you with one or more new terms (principal, interest rate, payment amount, and/or the number of payments).
Sounds simple enough, right?
Well, it would be if it wasn't for the fees.
Mortgage Refinancing Fees
Like most of their other high-profit products, lenders have done everything they can to complicate what would otherwise be a very simple decision. Lenders know consumers are only interested in who offers the lowest rates, so they lower their rates and make up the difference by charging a highly imaginative list of different loan fees (refer to the full refinance calculator on this page for a list and estimates).
Making matters worse, no two lenders have the same fee schedule. Not only does this make cost-estimation and rate comparisons anything but simple, but it also prevents me from being able to give you the exact cost of the fees. Instead, all I can offer is an estimation.
Average Closing Costs
Based on my research, the average refinancing closing costs charged by lenders can run between 3% and 6% of the refinanced loan balance.
To help you to put that in perspective, enter the current balance owed on your existing mortgage into the mini calculator below:
As you can see from the results, you will need to refinance at a rate low enough to more than offset the cost of the fees to realize any actual savings. And when I say "savings", I'm talking about real savings, not reduced payment savings.
When Are Refinance "Savings" Truly Savings?
If you have used mortgage-refinance calculators on other web sites, you may have noticed that some only return the difference between your existing house payment and the refinanced house payment. And if the refinanced house payment is lower, you will often see the calculated difference, followed by the statement, "Monthly Payment Savings."
There's only one problem. Unless the total cost of refinancing (interest plus closing costs) is less than the cost of not refinancing, the term "savings" cannot and should not be used in the results.
If you refinance at a lower rate but extend the payoff period out longer than the existing loan term, there's a good chance that refinancing will actually end up costing you more money, as opposed to "saving" you money.
So please, just because the refinanced house payment is lower than your current payment, DO NOT ASSUME YOU WILL BE SAVING MONEY BY REFINANCING.
And if you happen upon a refinance calculator that does not calculate and compare the long-term costs of refinancing, I suggest you do your calculating elsewhere.
Why Refinance a Mortgage?
While their are many reasons to consider, here are some of the most common reasons for refinancing a mortgage:
- To get a lower rate: If interest rates have dropped, or your credit score has improved (qualifying you for a lower rate).
- To get a shorter term: If you'd like to pay your mortgage off ahead of schedule without incurring prepayment penalties.
- To cash out some of your equity: If you'd like to borrow money at mortgage interest rates instead of at consumer loan rates (not recommended).
- To get a lower payment: If a lower interest and/or a longer repayment term will make the payments more affordable.
Of course, mortgage lenders will likely tell you the best reason for refinancing is so you can lower your payment amount, so you can have more money to spend on fun things and activities. However, as noted earlier, if you're not careful, a lower payment now can cause you to have less "fun money" in the future ... much less!
Should I Refinance My House?
In my opinion, you should only refinance if your existing mortgage is fairly recent (most interest is paid in the early portion of the repayment term), and if doing so will save you money in the long run.
But what if you can't afford the size of your current monthly mortgage payment? Then you probably bought more house than you could actually afford (check the House Affordability Calculator to see if that might have been the case.)
Most people I know would be far better off if, instead of refinancing, they sold their over-sized home and purchased a more practical size home -- financed at the lower rate.
And by practical size, I mean a less expensive home that has lower property tax, insurance, utility, and maintenance costs. But no one wants to hear that. It seems most would rather live in their dream homes even if it means struggling to pay the nightmare payment and expenses.
In any case, if you have the opportunity to refinance at terms that will reduce your overall cost of repaying the home loan (including closing costs), I would proceed, but with the utmost caution. Why? Because ...
Loan Officers Don't Get Bonuses for Saving You Money
If you have determined that refinancing your existing mortgage will save you money in the long run, make sure you request a detailed breakdown of all upfront costs, along with an amortization schedule showing principal and interest breakdown and totals. Also be sure to get a copy of the loan agreement, along with a magnifying glass to make sure you can scour every word of the fine print.
Be especially watchful for any verbiage related to "prepayment penalties," as some mortgage companies will offer you low, or no-cost refinancing, but often at the expense of higher interest rates and stiff prepayment penalties that will prevent you from getting a cheaper loan at a later date.
How To Refinance Your House
If you are serious about refinancing, here the the steps I recommend:
- Read A Consumer's Guide to Mortgage Refinancings: This guide is located on the Federal Reserve Board's website, but refers readers to the Consumer Financial Protection Bureau for recent regulatory changes, as well as additional information about shopping for and using consumer financial products.
- Research your home's current market value: If your market value has increased, thereby lowering your Loan-To-Value ratio, refinancing may allow you to eliminate Private Mortgage Insurance (PMI).
- Find out your credit score: Lenders will want to know your credit score before they will quote you a rate. The lower your credit score, the lower the interest rate you will qualify for.
- Shop for the best rate: Start with your current lender as they may be able to offer you discounted closing costs (no appraisal, etc.). Always request a firm estimate of the loan fees from those lender's offering the best rates (do so sparingly, as a sudden jump in the number of credit checks might have adverse effects on your credit score). This is to ensure lower rates or closing costs aren't being offset by higher fees.
- Gather all data about your current mortgage: Find out your current payoff, principal and interest payment, interest rate, PMI payment, and prepayment penalty (if any), then use the refinance mortgage comparison calculator on this page to see if refinancing will end up saving you money for as long as you plan to stay in your present home.
- Weigh refinancing against principal prepayment: Use the extra payment mortgage calculator to see if making extra principal payments can achieve the same or better savings than refinancing.
- Contact the chosen lender: If the calculations indicate refinancing will generate savings over and above the costs, contact the lender you decided on during step #4 and tell them you are ready to start the process.