Making Sense of Refinancing Mortgages

Most people take advantage of a drop in interest rates to refinance, but it is also an opportunity to build more equity.

Refinancing is the powerful right that you (the borrower) have to terminate the loan contract by repaying the loan whenever you wish. The exception to this is if you agreed to a prepayment penalty on your current loan.

CAUTION: Prepayment penalties are almost never favorable to borrowers. They are used by loan officers to earn higher commissions at your expense.

By contrast, unless you are in default, your lender cannot terminate the contract and force you pay the money back. Sadly, few topics in real estate financing are subject to more misconceptions than refinancing, meaning the right to refinance is often not exercised as intelligently as it could be.

First, many homeowners do not remember the details of their current loan, such as the exact interest rate. Without this knowledge, they cannot make meaningful comparisons with current loan possibilities. So if you think that you might benefit from a refinance, dig out your loan documents and make notes so you know the details of your current loan.

Second, refinancing should be done within the context of a larger financial plan that takes into account your age, earning power, assets, and your goals and plans.

Third, many people are intimidated by lenders and are hesitant to inquire about how a refinance might benefit them. The most frequent error is concentrating on the negative -- the cost -- rather than on the positive -- the savings. In considering the big picture, you want to refinance only when the benefits exceed the cost. Read on for how to do a cost-benefit analysis.

You should refinance when a drop in interest rates is sufficient to repay the costs of a refinance in a reasonable period of time. There are a number of interactive calculators on the Internet to help you work through these numbers and make a decision. You will find some good ones here: http://www.mtgprofessor.com/calculators.htm

First, you should analyze the costs. Here are some hints about what numbers to use.

WARNING: You probably have heard that all of these costs can “go away” if you get one of the heavily advertised zero-cost loans. Don't fall for that line! The interest rate goes up so much that it wipes out the benefits. Pay the normal costs as above and you'll benefit even more.

Next, enter your current interest rate, the interest rate on new loans, and the costs you developed above into the calculator. It will give you a rough idea as to whether you can benefit from a refinance.

NOTE: a problem with all of these calculators is that they base the calculations on the monthly payment that includes principal and interest. But the ONLY THING THAT COUNTS IS INTEREST!!!!! When you throw in the principal part, it skews the calculations, making it look worse than it really is.

The benefits are also a function of dollars, not percentages, so look at the dollars. For example, let's say you could lower your interest costs by $1,000 per year and the upfront costs are $3,000. In this example, you get back your costs in three years, an attractive transaction for most people.

WARNING: Almost everyone focuses on how much the monthly payment will decrease. This is an incorrect approach. You may remember from the first article in this series that a far better solution is to see how much a refinance can reduce the term of your loan. For most people, there are far greater benefits in maintaining the same payment after a refinance. It will knock years off of the life of the loan and dramatically reduce the total interest paid.

If the calculations look good, you'll need to sit down with an expert to get precise numbers for your loan amount and area. I cannot stress enough the power of an experienced, trustworthy loan officer. There are so many jerks out there that want to confuse you. They make more money off of confused borrowers! Most would not even know how to make the calculations like we did in the first article in this series. If you are going to get the most benefits, get an expert to help you.

Summary

• Many homeowners do not know the current status of their mortgage. Therefore, they cannot determine when a refinance could benefit them.
• Any refinance plan should be undertaken within the context of a larger financial plan, not just to reduce the monthly payment.
• You should refinance when a drop in interest rates is sufficient to repay the costs of a refinance in a reasonable period of time.
• Rather than reducing your payment, you should probably keep your payment the same or increase it so as to pay off your loan more quickly.

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