A Personal Finance Guide to Home Refinancing
Preparing to Refinance
To maximize the benefit you get from your refinance, consider preparing both yourself and your home for the process. While a refi may be less stringent than getting a purchase mortgage, your lender will usually scrutinize your income, your expenses and your credit. “Your credit score can impact your interest rate and how much you can borrow,” explains Sacramento-area mortgage banker Mark Van Biber. “The same basic good financial practices that helped you buy your house will help you refinance it. If you need help cleaning things up, talk to your mortgage banker.”
Many refinance mortgages require an appraisal to establish the value of your house. The higher your appraised value, the more you can borrow, which makes the appraisal particularly important if you're looking to pull cash out of your house. “Appraisers are professionals, but they're also human, which means that they can be influenced,” explains Van Biber. You might not be able to increase your house's value by cleaning its interior and exterior, sprucing up your landscaping and fixing any glaring cosmetic issues like a hanging roof gutter or broken window, but you'll reduce the risk that the appraiser reduces your value for the perception that your house is poorly maintained. Preparing a list of all of the improvements that you made to your house will also help your appraiser to squeeze as much value out of it as possible.
Refinancing can lower your payments in two ways. The first occurs if you can lower your interest rate. For example, going from a 6.25 percent to 4.5 percent on 30-year $200,000 mortgage will lower your monthly principal and interest payment from $1,231 to $1,013. The second occurs if you pay your loan down. If you take out a 6.25 percent 30-year $200,000 mortgage and pay on it for ten years, you'll only owe $168,475 at the end of the period. Refinancing that lower amount at the same 6.25 percent rate will lower your payment to $1,037. If you can also refinance that lower amount at the lower 4.5 percent rate, your payment will go down to $853.64.
Taking Out Cash
“Refinancing to take out cash is a great idea. It's also an awful idea,” says Van Biber. If you have equity in your house, a cash-out refi usually lets you tap into that money at a low interest rate. However, you'll have to pay off the loan over the life of your mortgage. Pulling out money to improve your home by making an addition or doing a major remodel is frequently wise, especially since you are also increasing your home's value. On the other hand, while doing a cash-out refi to pay off credit cards might save you money, if you run your credit cards back up, you could end up digging yourself into a deeper financial hole: you now have a higher mortgage payment and you still have credit card payments. “Before you pull cash out, ask yourself this: Do I want to be paying for this 29 years from now?” advises Van Biber.
The One Drawback
Refinancing has one drawback, though. “When you refinance, you're starting the process of paying down your mortgage all over again,” points out Van Biber. In the above example, if you refinanced your 30 year loan after 10 years into another 30 year loan, you'd end up making 40 years' worth of payments. Furthermore, he adds, “Mortgages are front-loaded with interest, so you don't pay that much off in the beginning." With a 30-year loan, you make a third of the payments in the first 10 years, but you pay off only about one-sixth of the balance.
There's a way that you can refinance and avoid this problem. “Why not refinance into a shorter term-loan?” asks Van Biber. You might not save as much money every month if you refinance your 30-year loan into a 20-year loan, but you can still save money, and you'll shave years of payments off your mortgage. Even better, shorter-term loans usually qualify for a lower interest rate.