The primary reason couples choose to refinance their home mortgages is because of low mortgage interest rates. However, before refinancing, they should be aware that sometimes they may end up paying more, not less, for a mortgage because lenders charge new types of fees, and loan arrangements can be complex.
When to refinance
If you're planning to live in the house for more than five years and don't expect a significant increase in your salary (cost of living increase or slightly more), moving from a higher interest rate to a lower one or changing from an adjustable interest rate to a fixed-interest-rate mortgage could be worth considering. The most popular mortgages are conventional fixed-rate 15 to 30 year loans.
For homeowners who aren't planning to stay in their homes for more than five years or who can look forward to big salary increases, spending the money to refinance may not be the wisest choice.
Adjustable rate mortgages (ARMs)
If you are buying a home and do not plan to stay in the home for more than five years, you might want to consider an adjustable-interest-rate mortgage.
First-year payments on ARMs are generally much lower than conventional fixed-rate mortgages, as long as interest rates stay down. The fear that interest rates could rise, causing your monthly mortgage payments to rise, can be partially offset by taking an adjustable rate mortgage with annual and overall limits on interest rate increases. The most common interest rate limit offered by mortgage lenders is 2 percent annually with a maximum of 5 percent over the life of the ARM.
If you choose an ARM, make sure the limits are in writing and are spelled out clearly in the mortgage contract. In addition, check to see if there's an interest floor. Some ARMs do not decrease if interest rates drop. Before signing the agreement, be sure mortgage rates will be reduced if interest rates drop.
Before refinancing, figure out exactly how much it is going to cost you. The advertised interest rate seldom tells the whole story. Additional charges and fees can raise the cost of refinancing to as much as 20 percent.
The biggest refinancing expense is prepaid interest, called discount points. It's typical for discount points to be 1 to 3 percent of the requested loan amount, but they can go as high as 10 percent. When comparing interest rates, always include this cost. A low-interest loan with high points can easily cost more than a higher-interest-rate loan with lower points. Ideally, refinancing would cost 0 points.
The mortgage company's refinancing fees can also be expensive. Some lenders charge a flat $250 to $700 for an application fee; others charge a percentage. Those that charge a percent of the loan generally charge between 2 and 4 percent. Therefore, a 2 percent application fee for a $100,000 loan would be $2,000. If the fee is nonrefundable, you stand to lose a substantial amount of money if the mortgage refinancing isn't approved. In addition, closing costs can vary dramatically from one lender to another. Generally, lenders who charge closing costs charge from 2 to 10 percent of the value of the loan. If at all possible, do not roll these fees into the loan. By doing so, you will be paying for them over the duration of the loan. Pay for these fees out-of-pocket.
More refinancing cautions
There are four primary issues about which you should get clarification before you agree to a refinancing contract.
- Negative amortization. Negative amortization of an adjustable loan can be devastating when you decide to sell the house. If your mortgage rates remain fixed but the interest rate rises, less of your monthly payment is used to pay off the principal. If rates rise a lot, the higher interest due is added to the principal. Then, when the house is sold, you might end up owing the mortgage company more than what was originally borrowed.
- Change in mortgage collection company. If your mortgage company sells your loan to another lender, there's a chance the new company will send a payment book automatically. So, you begin making payments to your new lender, instead of the originator of the loan. However, be sure the originator has “signed-off” or else you may be perceived as defaulting on the original loan. If you see any change in your mortgage processing, contact your originator immediately for an explanation in writing.
- Private mortgage insurance. This insurance is generally required only when down payments of less than 20 percent are made on the property. Charges for this insurance are usually .5 to 2 percent initially and then .33 to 2 percent annually. To prevent this expense, be sure you are refinancing 80 percent or less of the appraised value of the house.
- Prepayment penalties. This expense will show up when you sell your home. A prepayment penalty means that when you sell you will have to pay three to six months worth of interest before the deal is closed. If you have a prepayment penalty in your refinancing agreement and move in five years or less, all of your profits from the sale of the house could be dissolved by a prepayment penalty.
As interest rates continue to fall, many homeowners are becoming anxious to refinance their home mortgages in order to capitalize on the interest savings. However, before finalizing any refinancing agreement, be sure you know the total amount that you will be paying for the refinancing, how much the new mortgage will cost you monthly, and how much it will cost over the length of the loan.