Foreword

Refinancing

1. Banking. A loan that adds to the principal balance owed, usually for property or home improvements, and alters the payment amount and terms.

2. Finance. Issuing new securities at a lower interest rate, or extended maturity. Also called Refunding.

3. Real estate. To extend existing financing to new properties.

4. Mortgages. Revising a mortgage loan and modifying scheduled debt payments, often to reduce finance charges or to modify the loan payments.

Mortgage Refinancing

Owners of residential or commercial real estate use a similar method to analyze their refinancing decisions. In residential real estate the conventional wisdom applies the "2-2-2 rule": if interest rates have fallen two points below the existing mortgage, if the owner has already paid two years of the mortgage, and if the owner plans to live in the house another two years, then refinancing is feasible. However, this approach ignores the present value of the related cash flows and the effects of the tax deductibility of interest expense and any related points.

Therefore, a better analysis of a mortgage refinancing decision should be conducted as follows:

1) Calculate the present value of the after-tax cash flows of the existing mortgage;

2) Calculate the present value of the after-tax cash flows of the proposed mortgage;

3) Compare the outcomes and select the alternative with the lower present value.

The interest rate to be used in steps one and two is the after-tax interest cost of the proposed mortgage. Paying off an existing loan with the proceeds from a new loan, usually of the same size, and using the same property as collateral. In order to decide whether this is worthwhile, the savings in interest must be weighed against the fees associated with refinancing. The difficult part of this calculation is predicting how much the up-front money would be worth when the savings are received. Other reasons to refinance include reducing the term of a longer mortgage, or switching between a fixed-rate and an adjustable-rate mortgage. If there are prepayment fees attached to the existing mortgage, refinancing becomes less favorable because of the increased cost to the borrower at the time of the refinancing.

Some of the related terms for Mortgage refinancing are:

• Financing
• Balloon Loan
• Rate-Improvement
• Refund
• Floating Debt
• Prepayment Risk
• Rollover Mortgage

Sometimes refinancing involves the issuance of equity in order to decrease the proportion of debt in the borrower's capital structure. As a result of refinancing, the maturity of the debt may be extended or reduced, or the new debt may carry a lower interest rate, or some combination of these options. Refinancing may be done by any issuer of debt, such as corporations and governmental bodies, as well as holders of real estate, including home owners. When a borrower retires a debt issue, the payment is made in cash and no new security takes the place of the one being paid off. The term "refunding" is used when a borrower issues new debt to refinance an existing one.

Reasons for Refinancing

Want to save more

Reduce monthly payments by getting a lower mortgage rate or a longer loan term. In the second case, your monthly savings increase but you will be paying a larger amount of interest for the life of the loan.

Want to pay down your mortgage quickly

Shorten the length of your mortgage by reducing the period of repayment. Monthly payments will no doubt go up, but you will be able to save more in the overall interest payment. Moreover, it will allow you to get home ownership in a short time.

Need extra cash

Borrow more than the unpaid loan balance if you have enough home equity. With the extra cash, you can pay off high interest debts such as credit card balances or installment loans. You gain out of it as the interest on these debts are not-tax deductible unlike the mortgage interests.

Wish to pay off a high interest second mortgage

If there's enough equity at your home, you can refinance your second mortgage and combine both the loans into a single loan. The monthly payment on the new loan is likely to be lower than the combined payments on the first and second mortgages.

Want to convert from an ARM to an FRM

This allows you to lock in at a low rate. You can thus repay the loan with stable monthly payments rather than variable payments throughout the life of the loan.

Want to get rid off PMI

If your current loan balance is below 80% of the new appraised value of your home, you can refinance and stop paying PMI.

When to Refinance?

Generally, there are two good times when it's wise to refinance your mortgage. If you've got an adjustable rate mortgage, one of those times is during periods of rising interest rates. If you refinance to a fixed rate mortgage, particularly to a rate similar to your present low adjustable rate, you'll avoid the higher costs when the adjustable rates start going up.

The other time it's a good idea to refinance is when you'll save money by getting a lower interest rate. In this case, you'll want to make sure that your monthly savings will pay back your refinancing costs while you're still living on the property. If you sell your home before your refinancing has paid for itself, you won't be saving anything. If you are experiencing cash flow difficulties, you may be tempted to lower your monthly mortgage payments by refinancing to extend the term of the loan. From a savings perspective, this is not a good reason to refinance. Unless you get a lower interest rate on the new loan as part of the bargain, you're not really saving any money; in fact, the reverse will be true.

If you extend the term of your mortgage without changing anything else, you might loosen your tight cash flow situation, but you'll actually pay more total interest on the mortgage in the long run. Refinancing can be a way out to keep you from making higher payments but you can only get the maximum benefits when you're into the process at the right time. Here are a few conditions under which you may seek a refinance loan.

You have the home equity to help you borrow It is feasible to can go for a refinance when you have built up at least 10% equity in your home (For Fannie Mae owned mortgages, the value is 5%). It is also possible for you to choose the option if your equity is less than 5%, but you may have to pay a certain amount of cash in order to make up for the difference in the equity.

You find that current market rates are low It's better to follow the 2% Rule which suggests that you can enjoy the benefits of a refinance if you can secure an interest rate 2% below the rate on your current loan. The interest savings will help you to recoup the costs you've paid for the new loan provided you stay in the property for a certain period of time (break-even period). However, there are no-cost as well as low-cost refinance loans wherein the costs are included into the loan. You can expect a slightly higher rate on such a loan but if it's lower than your current rate, then it's still a suitable choice.

You haven't been late on the payments There is no such limit on the number of times you can go for a refinance. Most lenders prefer that you have no late payment for the past 12 months before you switch over to a new loan.

When not to Refinance?

Refinancing does not make sense under the following situations:Your property value has gone down If your property value reduces and you refinance up to 80% of the reappraised value, your original mortgage amount may be higher than this amount. Thus, the new loan will not be sufficient enough to help you pay down the existing one.

You are paying off the first loan for a long time If you are making payments on a long term loan, say, a 30 year mortgage for the past 10 to 20 years, then refinancing to another 30 year loan will not be a good option as it may increase your overall payment.Your credit profile isn't impressive If you have messed up with your credit by delaying payment on loans and bills, there is hardly any chance that you will qualify for a low rate mortgage. Off course there are lenders in the subprime market, but it's better to avoid them as they'll possible charge you with higher rates and fees.

You have used up enough equity in your home Refinancing may not be that useful if you have already used up 90% or more of your home value in taking out a mortgage or any home equity loan. You won't be able to get the best rates available in the market as when you refinance a 90% LTV loan, you will probably require a loan of that value or higher. This will be quite closer to being a 100% financing option and hence the rates will be comparatively higher.

You have a few years left on the current loan If there is only a few years left on your current loan, then there's not much use refinancing it with a long term loan. You may need extra cash but with a long term loan, you may end up paying more throughout the loan period. In this case, if you do not move according to a planned budget then it will be hard to carry out your day to day expenses.Refinancing will make sense if you are into it for the right reasons and at the right time.

You need to decide upon the various ways of refinancing and the possible loan options that will suit your needs and fit into your situation.

Breakeven Period

To save money, you must stay in your house longer than the "break-even period" – the period over which the interest savings just cover the refinance costs. The larger the spread between the new interest rate and the rate on your existing loan, the shorter the break-even period. The more it costs to obtain the new loan, the longer the break-even period. But beware! The break-even period is not the cost of the new loan divided by the reduction in the monthly mortgage payment. This widely used rule of thumb is a misapplication of the principle that when explaining something to the consumer one should "keep it simple." Simple is good, except when it’s wrong!

The rule of thumb does not allow for the difference in how rapidly you pay off the new loan as opposed to the old one. Lets say that in 1992 you took out an 11% 30-year fixed rate loan, which now has a $100,000 balance and 21 years to run. You refinance into a 7% 15-year loan at a cost of $3,750.

Monthly payment on the old loan = $1019

Monthly payment on the new loan = $899

Reduction in monthly payment = $120

$3750 divided by $120 = 31 months

The rule of thumb says that you break-even in 31 months. However, because of the shorter term and lower rate on the new loan, in 31 months you would owe $7,041 less than you would have owed on the old loan. So, the rule of thumb in this case seriously overstates the break-even period. Taking account of differences in the loan balance, you would actually be ahead of the game in 12 months, as shown below:

Savings in monthly payment: $120 for 12 months = $1440

Plus lower loan balance in month 12: $2620

Equals total saving from refinance: $4060

Less refinance cost: $3750

Equals net gain: $310

Next consider the case where an 11% loan taken out in 1992 was for 15 years, and now has only 6 years to run, while you plan to refinance into a 30-year loan. With the remaining term shorter on the old loan and longer on the new one, the difference in monthly payment rises to $1238. Using the rule of thumb the $3750 cost would be recovered in only 3 months. But this fails to consider the slower loan repayment on the new loan. Taking account of the slower repayment, you don’t actually come out ahead until 14 months out. The rule of thumb (dividing the upfront cost by the reduction in mortgage payment) approximates the true break-even period only if the term on your new loan is close to the unexpired term on your old loan.

In other circumstances it can lead you seriously astray. The rule of thumb also ignores the fact that if you had not refinanced you could have earned interest on the money you pay upfront to refinance; and if you do refinance and the payment is reduced, you can now earn interest on the savings.

Higher Rates

The Processing Capacity Problem

The boom stretched to the limit the capacity of lenders to process loans. Reluctant to add more employees when the boom could fizzle out at any time, lenders preferred to lengthen the processing period and let borrowers queue up for longer periods. But purchasers often have closing dates they must meet, and lenders strive to give them priority over refinancers. Pricing refinance a little higher is one way to do this because it cuts the number of refinancers in the queue.

The Lock Risk Problem

Another factor was at work as well. It costs lenders more to lock the interest rate on refinance loans than on purchase loans. Usually, this is not important enough to cause a difference in pricing, but that also changed during the refinance boom. When lenders lock, they assure the applicant that the rate will hold if market rates increase after the lock. Lenders lose if market rates are higher when they close, and they gain if market rates are lower. If loan applicants who lock always went to closing, over time, lenders would gain as much from rate declines as they lost from rate increases. But in practice borrowers do not always close, and the fall-out as it is called is larger when rates are falling. Some applicants are "lock-jumpers". They lock, and if rates subsequently decline, they find another loan provider and lock again at a lower rate. Locking thus imposes a net cost on lenders.

This cost is larger on refinancings than on purchases because lock-jumping is more common among refinancers. Borrowers who are refinancing usually are flexible on when they close. Most purchasers, in contrast, must close on a specific date and don’t have time to restart the process with another lender. The prolonged refinance boom increased the number of refinancing lock-jumpers. An unusually large number of borrowers refinanced multiple times within just a few years, learning the ropes in the process. One thing they learned is how to lock-jump. This widened the difference in lock cost to lenders between refinancings and purchase loans. Lenders and brokers were partly to blame for this because they only rarely put applicants on notice that they are committed by a lock. They fear that such a warning in itself could send the applicant running to another loan provider. But the result was to raise the cost to all those who refinance.

Cost of Refinancing

Your refinancing cost is the total of any points, closing costs, and private mortgage insurance (PMI) premiums that you pay when you take out the new loan. In addition, any lost tax savings must also be regarded as part of the cost of refinancing. There are times when lenders offer "no points, no closing costs" refinancing deals. Check the terms of the offer carefully to make sure that you understand what's involved. Points are prepaid fees. One point equals 1 percent of the amount you're borrowing, and any points you're charged are usually deducted from the mortgage proceeds you receive. Mortgage lenders typically charge one point as a loan origination fee. Beyond that, lenders may charge additional points on loans with interest rates below the current market rate. By doing so, the lender makes a little more money up front, and you get a lower interest rate on your mortgage.

So, if you're going to stay in your house for a long time and can afford to do so, paying more points in the beginning may get you a better interest rate and save you more money in the long run. Your closing costs include a variety of fees, such as an appraisal fee, a title search fee, recording fees, and other fees associated with processing and finalizing your mortgage. If your loan-to-value ratio is greater than 80 percent of the appraised value of your property, you may also be required to carry PMI. The premiums for this insurance usually become a portion of your new monthly mortgage payment and thus reduce your savings from refinancing. In addition, you may discover hidden costs. For example, if you're paying less interest on your new mortgage, you'll have less to deduct on your income tax return. If this makes your tax payments higher, your savings will be further offset. Once you've determined what your refinancing costs will be, you can then determine how long it will take for your refinancing to pay for itself. To do so, divide the total of the points and closing costs that you paid by the net monthly savings that the new loan provides you. Your net monthly savings will be your interest savings less any PMI premiums and tax advantage losses expressed as monthly figures.

For example, assume you refinanced $200,000. You paid two points and total closing costs of $1,800. You got a great interest rate on the loan, so you'll save $80 a month in interest charges. However, your PMI premiums are now $10 per month higher, and you've lost tax savings of $120 a year, or $10 per month. Your refinancing costs are $3,800--two points of $1,000 each and $1,800 in closing costs. Meanwhile, your net savings are $60 per month--$80 per month saved interest less $10 per month increased PMI premiums and $10 per month lost tax savings. If you divide $3,800 by $60, you'll find your refinancing will pay for itself in a little over 63 months.