Refinancing is the process of paying off an old loan by taking on a secured debt. A secured debt is a loan that is backed by collateral. In case of refinancing, the collateral for the old loan secures the new debt. Home refinancing is the most popular example of refinancing in the modern world. As the name suggests, 'the home' against which the first mortgage was obtained, functions as the collateral for refinancing.
Determining Savings on Interest Payments
Home mortgage can be broadly classified into the following categories: Fixed Rate Mortgage (FRM) and Adjustable rate mortgage (ARM). A fixed-rate level-payment 30-year mortgage is the most common example of an FRM. As the name suggests, the interest rate on the FRM is fixed. The FRM has an amortizing schedule which means that the monthly payments have an interest as well as a principal component. The interest payments are calculated on the principal balance remaining, at the beginning of each month.
The proportion of interest in the monthly payments decreases over time while the principal component of the monthly payment increases, since the monthly payments remain constant. On the other hand, the interest rates on the ARM is adjustable, and depending on the interest rate movements the monthly payments can increase or decrease. The ARM has a mandatory cap on interest rates. In other words, if the variable rate increases above the ceiling, the floating rate starts functioning as a fixed rate.
The temptation to refinance arises when there is a drop in the interest rates. People generally try to finance an old loan, by taking on a new loan with lower interest rate payments. However, a drop in interest rates alone is not a sufficient criterion for refinancing. Generally, refinancing is recommended if one is able to reduce the interest rate payments by 1% to 2%.
The process of refinancing again involves certain costs, like the brokerage. These have to be paid upfront. We can convert an ARM into an FRM or vice versa, depending on the savings. People prefer to convert an ARM to an FRM in case of uncertainty regarding the future direction of interest rates.
Home Equity Appraisal
Home equity is the amount of equity that has been accumulated by the homeowner over time. This is calculated using the following formula:
Home Equity = Market Value of the Home - Remaining Mortgage Balance
Refinancing might not be possible if the amount of the remaining mortgage balance is more than 105% of the market value of the house. This has become a common scenario after the housing bubble burst and the home prices crashed. Home appraisal is not only important from the perspective of refinancing, but also from the point of view of obtaining a home equity line of credit (HELOC).
Making prepayments on the mortgage by refinancing is permissible. However, sometimes there might be a penalty for prepayment in order to provide protection to the MBS (mortgage backed security) investors. The period of prepayment protection is generally short. In case we decide to refinance during the call protection period, we will have to pay a penalty. This will increase the cost associated with refinancing.
Reducing the Repayment Period
It would be a good idea to ensure that refinancing reduces the term of mortgage while keeping the monthly payments the same. This would result in greater principal payments and reduced interest payments, since the interest is calculated on the balance outstanding at the beginning of each month. This not only reduces the term of the mortgage but also increases the equity on the home.
Consolidation of debts is the process of replacing many small loans with one loan. Many of us might have a bunch of loans, each carrying a different rate of interest and a different maturity period. Consolidating these in the form of a single home equity loan might help us manage our payments. The interest on the consolidated loan might also be tax deductible. However, one must keep in mind that debt consolidation results in replacing higher interest rate loans with a lower interest rate loan and this lengthens the maturity period. Debt consolidation might also result in a greater mortgage balance and may reduce home equity.
Finding the Right Mortgage Broker
This is the final step towards refinancing. One should try to find a good and an unbiased mortgage broker. The broker would be able to provide information on the kind of documents that would be required for refinancing. Banks and lending institutions also provide similar information on their website. Most of the information regarding guidelines for refinancing can be obtained from Freddie Mac and Fannie Mae.
As of May 21, 2009, the 30-year FRM was carrying an interest rate of 4.82% while the 5½ year ARM interest rate was at 4.79%. This might be a golden opportunity for many of us to refinance our home. But remember, a low interest rate is necessary but not a sufficient condition for refinancing.