Refinancing your home loan
Advantages
Refinancing may be undertaken to reduce interest costs (by refinancing at a lower rate), to extend the repayment time, to pay off other debts, to reduce one’s periodic payment obligations (sometimes by taking a longer-term loan), to reduce or alter risk (such as by refinancing from a variable-rate to a fixed-rate loan), and/or to raise cash for investment, consumption, or the payment of a dividend.
In essence, refinancing can alter the monthly payments owed on the loan either by changing the loan’s interest rate, or by altering the term to maturity of the loan. More favourable lending conditions may reduce overall borrowing costs. Refinancing is used in most cases to improve overall cash flow.
Another use of refinancing is to reduce the risk associated with an existing loan. Interest rates on adjustable-rate loans and mortgages shift up and down based on the movements of the various indices used to calculate them. By refinancing an adjustable-rate mortgage into a fixed-rate one, the risk of interest rates increasing dramatically is removed, thus ensuring a steady interest rate over time. This flexibility comes at a price as lenders typically charge a risk premium for fixed rate loans.
In the context of personal (as opposed to corporate) finance, refinancing a loan or a series of debts can assist in paying off high-interest debt such as credit card debt, with lower-interest debt such as that of a fixed-rate home mortgage. This can allow a lender to reduce borrowing costs by more closely aligning the cost of borrowing with the general creditworthiness and collateral security available from the borrower. For home mortgages, in the United States, there may be certain tax advantages available with refinancing, particularly if one does not pay Alternative Minimum Tax.
Risks
Most fixed-term debt contains penalty clauses (known as “call provisions”) that are triggered by an early payment of the loan, either in its entirety or a specified portion. In addition, there are also closing and transaction fees typically associated with refinancing debt. In some cases, these fees may outweigh any savings generated through refinancing the loan itself. Typically, one only rationally considers refinancing if the potential for a substantial cost savings exists, or if there is a need to extend the loan due to weak cash flow or other non-recurring commitments.
In addition some refinanced loans, while having lower initial payments, may result in larger total interest costs over the life of the loan, or expose the borrower to greater risks than the existing loan, depending on the type of loan used to refinance the existing debt. Calculating the up-front, ongoing, and potentially variable costs of refinancing is an important part of the decision on whether or not to refinance.
Reasons to be kept in mind while opting for refinancing are :
- Changing an adjustable-rate mortgage (ARM) to a fixed-rate mortgage.
- Reducing the interest rate in order to save money. If the mortgage taken has higher interest rate then the present interest rates, you need to take a refinance. If a mortgage is taken at a lower rate, then the monthly payments will be reduced. If you don’t stay in the house for which you have taken mortgage as well as refinance, then the cost and fees of refinancing will not help you save money.
- Changing an ARM to another ARM with better features or lesser interest rates as they restrict the increase in the interest rates or monthly payment which is called as CAPS. If the market offers a better ARM with lower cap then it will help in reducing the monthly payment in turn helping in more savings.
- Can transfer your equity to cash.
- Develop your equity quicker – if you have a saving after you have taken a mortgage, you can convert the existing mortgage to a short term mortgage so that you can own your house faster. Though the monthly payment might be more, you will be saving more money as you will be paying less interest at a lower interest rate.
Choose the right mortgage
- A fixed interest rate mortgage is better than an adjustable one as the interest rate remains the same throughout the period of the mortgage.
- A 15 years old mortgage is better than 30 years one as the longer the period of the mortgage, the more money will be spent on the loan. Though the monthly installment for 30 year mortgage would be lower than the 15 year mortgage, in the long run you would have paid about twice more on the house mortgage.
- There are various different types of mortgage for people buying the house for the very first time. Federal assisted loans are ideal for people with lower income so that they can also afford to buy a house.
