When you buy a home you obtain a mortgage, also called a purchase loan by mortgage professionals. It’s simply a loan to purchase a home. The bank or financial institution making your mortgage charges you interest – a fee for borrowing their money. That fee is represented as a percentage of the total amount you borrow, for example, 6% or 7.15%. But here’s the catch – interest rates change. If the Federal Reserve cuts the prime rate (the rate at which banks can borrow money from the Federal Reserve) then consumer interest rates fall. That means that you may be able to get a mortgage with a lower interest rate than your current mortgage.

Less interest = a cheaper monthly mortgage bill = significant savings over the life of your loan.

When you refinance you’re getting a new home loan (at a lower interest rate) to pay off your old home loan.

But how do you know if it makes sense to refinance? There are three basic reasons to refinance:

(1)  You want to get a new type of loan.
You may have originally obtained an ARM (adjustable-rate mortgage), but would like the steady predictability of a fixed-rate mortgage. Or maybe you like having an ARM but want to lower your loan’s lifetime cap to reduce the highest possible interest rate you could ever be charged. Lifetime caps on ARMs are usually around 5 or 6%, meaning that your interest rate can never go 5 or 6% higher or drop 5 or 6% lower than the rate you locked in at purchase.

Let’s look at how refinancing an ARM would affect its lifetime cap. Let’s say the original interest rate on your ARM was 7.75% and you have a 5% lifetime cap. That means that your rate can drop to as low as 2.75% but can also go as high as 12.75%. Now if you refinance to a 6% ARM your lifetime cap can drop to as low at 1% and rise only as high as 11% -- that’s a nearly 2% difference between the highest amount you could have to pay with your current loan and how much you could have to pay with a new, lower interest rate loan.

Or maybe you originally got a “balloon loan.” A balloon loan is a mortgage with an initial payment period at a low interest rate and then the entire balance of the mortgage due upon maturity of the loan. If your balloon is about to come due, you’ll have to pay off the entire remainder of the mortgage. If you’re not in a position to pay off the entire balance of the mortgage, you’ll want to consider refinancing to another type of loan to extend your payments over the full lifetime of the loan.

As you can see there are several cases where it makes sense to refinance not only to get a lower interest rate loan, but also a new type of loan.

2)  You want to tap into the equity you’ve built up in your home.
A home is most people’s biggest investment. And if you’ve been in your home for 10, 20, 30 years then you’ve built up some equity (savings) in your home. Maybe rates are low and you’d like to tap into that savings to help pay for a child’s college tuition; pay down debt, or make some home renovations. Refinancing to take some money out of your home is called a “cash-out refi.” Getting your hands on a little extra cash sounds enticing, but think twice before rushing to refinance.

First, remember that the money you take out of your home will be taxed as income so consider the tax implications before signing on the dotted line.
Second, be aware that your lender may charge a higher interest rate for a “cash-out refi,” because in essence you’re lowering the amount of savings you have in your home. Some lenders will add up to 1/2% to your interest rate if by refinancing you’re raising your LTV (loan to value) to 80 percent or more (meaning that you have 20 percent or less of your own cash savings built up in your home).

You can avoid the additional rate increase by either finding another lender who doesn’t charge a higher interest rate or you can take out slightly less cash from your home and keep your LTV at closer to 75%. Or you might want to consider other alternatives altogether such as obtaining a home equity loan, taking out a personal line of credit or looking into reverse mortgages as an option to tap into the equity of your home.

The higher the LTV, the less of your own money you have built up in your home. A 100% LTV loan means that you’re borrowing the total amount of the mortgage and have none of your own money invested. Lenders like to see homeowners have at least 80% LTV.

3)  You want to lower your interest rate and save on your monthly mortgage amount.

This is probably the most common reason people give for refinancing. It only makes sense – if you’re paying 8.5% interest on your loan and you have the opportunity to pay only 7%, why wouldn’t you? But there is more to refinancing than just the interest rate. There are a few things to consider and a little math to do before refinancing.

The Bottom Line When It Comes to Refinancing

Okay, so you want to lower your interest rate and pay less for your mortgage. But how do you know exactly when the interest rate has fallen enough to make it money-wise to refinance?

The widely referred to “2 percent rule” is that it makes sense to refinance if there’s a 2 percent difference between your current mortgage interest rate and the rate you could get if you refinance. But that’s not a hard and fast rule. In fact, if rates have fallen at LEAST 1 percent, you might want to consider refinancing. Obviously the bigger the spread between your current interest rate and the new refinancing rate, the quicker you’ll be able to recover the costs you’re going to have to pay to get the new loan.

Next to the interest rate, the most important thing to determine before you refinance is how long will it take to pay off the costs associated with refinancing and the actual amount of your new monthly mortgage.

Say your current mortgage is $1,600 and your lender says that you could save $180 a month on your mortgage by refinancing. Unfortunately you won’t really save the full $180 thanks to a little thing called taxes. That $180 is your pre-tax savings. With a new (lower) mortgage amount you’ll have less mortgage interest to deduct, which will affect your overall taxable income. So to determine how much you’re really going to save monthly:

• Determine what your current taxable income rate is .
• Take the amount you expect to save ($180) and multiply that by your tax rate (let’s say 28%).
• Subtract that amount from your expected savings to get your actual monthly savings.

Example: $180 (savings) x 28% (tax rate) = $50 (lost savings due to taxes)

$180 - $50 = $130 (new monthly mortgage savings)

$1,600 (current mortgage) - $130 (new savings) = $1,470 (new monthly mortgage amount)

Once you’ve determined what your new monthly mortgage amount will be, the next step is to figure out how long it will take to pay off the cost of refinancing your loan. That’s right, there is a cost to refinancing. Actually, the cost can be considerable. It can cost anywhere between say $2,000 - $6,000, ballpark, to refinance your loan. Remember that refinancing a loan means that your bank, credit union, or mortgage banker is closing out one loan and creating another completely new loan. That means a lot of paperwork, legal work, and well, money. So you’ll need to figure out if it makes financial sense to refinance.

Let’s say your lender tallies it up and tells you that it will cost you $3,500 to refinance your loan. If you divide the refi cost ($3,500) by the amount you expect to save ($130) then you come up with how many months it will take you to recover that cost.

Paying Off Refinance Costs

Example: $3,500 (cost to refinance)/$130 (monthly savings due to refi) = 27 months (to pay off refi costs)

In this case, if you plan on staying in the home longer than 27 months, it’s more likely that it makes sense for you to consider refinancing. If you know, or strongly suspect that you’ll move before then, it’s not as likely that refinancing makes sense. If you determine that you’ll be in your home longer than the amount of time it takes to pay off the refi costs, then you’ll recover not only those costs, but also the monthly savings in your new loan amount ($130 x 27 months = $3,510) and you’ll be paying less interest than with your previous, higher interest rate loan.

Homework

Before you rush out to refinance, there are a few questions you should ask any potential loan officer.

What interest rate are you charging for the type of loan I want?

How many points do you charge for refis? Remember 1 point = 1% of the mortgage amount. When you refinance, points are rolled into the loan and you’ll be paying them off as part of your monthly mortgage payment. But you still want to know what you’re paying on a monthly basis.

What are the other fees you charge to refinance? Fees can include recording fee, title insurance, notary fees, legal fees, etc.

What is the total cost going to be for me to refinance my loan?

What are the tax implications for refinancing my loan? A loan officer should double-check your math and make you aware of not only the federal income tax implications of refinancing, but also any state income tax implications. You don’t want to be caught by surprise come tax time, so check with a tax attorney or accountant if you need further clarification on tax implications of refinancing.

How long is it currently taking you to process and close refinancings? When rates are low and people are hot to refinance, it can take 2-3 months to process and close refi loans.

Can I lock in the rate? And if so, for how long? When it comes to refinancing, time can be your enemy. Rates can change rapidly. So you want to lock in, or be guaranteed, your new interest rate and know that the new rate will still be in effect when it comes time to close on your loan. For example, if your lender can only guarantee you a 30 day lock in period and it’s taking an average of 60 days to close a loan, you may be in for a rude surprise when it comes time to sign papers if the rate has risen.