Mortgage Refinancing 101
Are you thinking about refinancing your mortgage? You probably should as interest rates have never been this low. If so, consider these 6 questions:
1. 15- or 30-year term?
A shorter term offers a lower interest rate; a longer term has a lower monthly payment due to the longer time period to amortize the loan.
However, mortgages have a subtle benefit that can make a longer term worthwhile: the borrower has the option of making additional payments at any time. This “option value” is not well understood but can be worth a lot. Thus, you can always convert a longer term mortgage into a shorter one.
One way to decide is to pick a term that is shorter than the time when you expect to retire. You’d like not to have a mortgage payment in retirement.
2. Higher fees or higher rate?
When you take out a mortgage, you incur two types of fees:
- Various closing costs such as appraisals, title insurance, legal, documentation, and recording fees, etc.
- Points. This is a funny name that’s simply an additional fee and, more or less, represents the profit on the transaction. Each point is 1% of the borrowed amount.
When you’re shopping for a mortgage, the more fees you pay, the lower the interest rate you’ll receive. There is often a “no points, no closing costs” (aka, NPNC) option where the lender absorbs all the fees in exchange for you paying a higher rate.
How do you decide? If you expect to remain in the house — and keep the mortgage — for a long time, you’d want to minimize the interest rate in exchange for higher fees. If you expect to keep the mortgage for only a short period — e.g., you may move, refinance it again, receive an inheritance and pay it off — you’d want to minimize the fees in exchange for a higher rate.
The logic is that if you keep the mortgage for a short time, the fees dominate but if you do hold on to the mortgage for many years, the rate dominates.
3. Fixed or adjustable rate?
A fixed rate mortgage is one in which the interest rate is fixed for the entire term; an adjustable rate is tied to some index (e.g., 2-year Treasury bonds, the prime rate, etc.) and re-sets periodically based on the specified index value.
In more “normal” economic times, there are sensible reasons to opt for either structure. However, given how low fixed rates currently are, I don’t see any good reason to take the risk of a variable rate mortgage now.
4. Include other consumer debt?
If you have other consumer debt such as credit cards, it may make sense to roll these balances into a mortgage refinancing, assuming you have the equity to do so. Credit card balances typically have a much higher interest rate than your mortgage and you can save interest expense by paying off the credit cards.
However, there is also a risk in doing so. If, by transferring the balance from your credit cards, you feel enabled to run up new credit card debts, you’ll be worse off. You’d have a larger mortgage and a new credit card balance. Proceed cautiously if you’re considering this.
5. How much of a down payment?
Put down at least 20%. This is sensible because if you don’t have that much:
- It’s a yellow flag that you may own more house than you can probably afford.
- You may pay a higher interest rate for the mortgage.
- Lenders will require you to purchase private mortgage insurance (“PMI”). This is an additional monthly payment for insurance to protect the lender against a future default on your loan, given the lower amount of equity. This makes the house even less affordable.
6. Which lender?
Mortgages are a commodity service with little that distinguishes one lender from another. In most cases, your loan will be sold off to an institutional investor and serviced by a third party. Get quotes from more than one lender or mortgage broker and chose the one with the best combination of rate and fees.
Refinancing can be a hassle with lots of paperwork. However, it may save you thousands of dollars and be worth the effort.