Saving Money by Refinancing Your Mortgage

The term mortgage refinance simply means applying for and obtaining a new mortgage loan, not to purchase a home but rather to pay off the present mortgage loan on one's existing property.

Why would someone want to go to the trouble of getting a new loan when they already have a loan? There are a number of reasons that one might want to do this.

First, and probably the most common reason is that interest rates have dropped and the borrower wants a new loan with a lower rate of interest along with the lower monthly payment that goes with the lower interest rate.

Second, and this is somewhat related to the first, if you have had the present mortgage for some time, the remaining balance will have declined and a new thirty-year loan on the lower balance, even at the same interest rate, will have a lower monthly payment than the previous mortgage. Lowering the mortgage payment will result in increased cash flow (money left over after paying the monthly bills) for the household.

Third, and this is a very common reason, with rising housing prices people are now able to borrow more than they could when they purchased the home a few years ago (a major factor in determining the size of a mortgage is the value of the property securing it). Interest rates are lower on mortgages than they are on unsecured loans like credit cards, because the lender can always take the property and sell it to get their money back if the borrower defaults.

When people find themselves with a lot of high interest, unsecured loans and a home whose value has increased noticeably, find it advantageous to get a new mortgage in an amount higher than the amount of their current mortgage and use the extra cash to pay off their higher interest unsecured loans and credit card balances. This not only reduces the amount they pay each month to creditors, it also greatly reduces the amount of interest they are paying on their total debt each month. Further, in most cases the interest that is paid on the mortgage on one's home can be deducted from their income for tax purposes while interest paid on other loans is not deductible. Thus, consolidating debts with a new mortgage loan will usually not only save on interest but on income taxes as well.

While refinancing a mortgage often makes sense, it is not always a wise idea. The main problem with refinancing is the cost of points and other fees. Points on a mortgage loan refer to interest paid up front.

One Point is one percent of the loan amount. Points are often used to buy down or reduce the interest rate. Instead of paying say 10% on your mortgage you pay one point up front (1%) and have a 9% rate on the mortgage itself. Points can also be charged for other things such as the mortgage broker's (the person who brings the borrower and lender together) fee or to cover costs and profit of the mortgage bank (an organization that prepares the documents, originates the loan and then sells it to a bank or insurance company). Part of the points go to the loan officer who works with the borrower in making the loan.

Most loan officers now days work on commission and their commission comes from points. In fact loan officers usually have some control over the amount of points charged with their employer requiring a minimum of one to two points or more for the company and then whatever else the loan officer can get is kept as his or her commission. In a highly competitive environment, borrowers can shop and find loan officers, and sometimes mortgage banks themselves, who will reduce points in order to get the business. It works the other way also as I once spoke with a loan officer at a party who described how he and his fellow loan officers had a special class of points called pita points. PITA stood for Pain In The Ass and the pita points were an extra one-quarter to one-half percent charged to obnoxious customers who were a pain in the ass during the loan process. Ironically, these people were so busy making a nuisance of themselves over other matters that they failed to notice that they were paying more!

While buyers can pay the points and other fees (appraisal, credit report, termite inspection, deed and mortgage filing fees, etc.) with cash at the time of loan closing, many people accept the lender's offer to include these in the mortgage - which, of course, adds to the amount of interest you will pay over the years. Whether you pay cash or finance the fees by including them as part of the new loan, the fees and points are a cost to consider along with the new rate on the loan. Generally, the savings in interest on the new loan should be sufficient to allow you to recoup the cost of the fees and points within about a year, otherwise, if it takes much longer, the money paid for fees and points will offset the savings on the lower interest rate. Sites like Bankrate.com, Yahoo Finance, Google Finance and others all have calculators that allow you to calculate how long it will take you to recover the cost of the points and fees paid through the savings in interest.

Just as it makes sense for a business or government to issue (sell to the investing public) long term bonds when they can get a low interest rate and use the proceeds to pay off higher interest short-term borrowings (this is referred to as restructuring debt), it also makes sense for a homeowner to take advantage of a drop in interest rates on mortgages to refinance and use the extra proceeds to pay of higher interest short term loans and credit card balances. This reduces both the household's interest expense as well as the amount of money going to pay bills each month. Refinancing for the purpose of making a major improvement to the property is another good reason for replacing an existing mortgage loan with a new, higher one as the improvement should increase the value of the property thus offsetting the larger debt. However, except in extreme circumstances (such as the loss of a job or major illness) it is not a good idea to refinance a mortgage and use the excess cash for current expenses such as a vacation, day to day living expenses, etc. as one ends up spending the borrowed funds on things consumed today while having to pay for them over the next 20 to 30 years.

Often when there is a major drop in interest rates people will find that they can refinance at the new, lower rate and, by keeping their monthly payment the same, have their mortgage loan paid off in half the normal time. This can be a good idea, however, before doing this one should review their tax situation to make sure that this will not result in significantly higher income taxes as a result of their no longer having the mortgage interest deduction.

Like other major life decisions, the decision to refinance or not refinance depends not only upon external factors such as current interest rates but on the household's current financial situation and their assessment of what the future will bring as mortgage loans are generally financial commitments spanning the next fifteen to thirty years.