What to know before refinancing your home loan
Mortgage rates have hovered near three-year lows recently, leading many homeowners to wonder if now is the time to refinance. I asked Craig Strent, CEO and co-founder of Rockville, Maryland-based Apex Home Loans, one of Washington's largest independent mortgage banking firms, what they should keep in mind before refinancing their home loan. Our conversation has been edited for clarity and length.
Question: What should I consider when deciding whether to refinance my mortgage?
Answer: Consider how many years remain on the loan you have and how much longer you will stay in your home. From there, look at the costs of obtaining a new loan compared to the amount of interest it will save you. Be careful not to base your analysis just on the cash-flow savings. Lowering your interest rate but resetting the loan to 30 years without having a plan to leverage the savings on the refinance may cost you more in the long run. A homeowner expecting to move in the next couple of years probably does not need to refinance. Homeowners in adjustable rate mortgage loans and those homeowners with private mortgage insurance may want to take advantage of low interest rates to reset their ARM, move into a fixed rate, and/or remove or reduce their mortgage insurance.
Q: What is the difference between a loan with closing costs and a "no cost" loan?
A: All loans have closing costs, it's just a matter of who pays them. There is no free lunch. In a standard refinance, the closing costs -- costs associated with establishing a new loan such as appraisal, title and lender fees -- are typically rolled into the loan. An alternative is to opt for a "no cost" loan, which substitutes a slightly higher interest rate in lieu of costs. This higher rate provides the lender a premium when they sell the loan and that premium is fronted by the lender to pay closing costs on behalf of the borrower. For homeowners who may not remain in their home for many years to come or for those who think they will perhaps refinance again soon, a "no cost" refinance is a good way to take advantage of lower rates without losing any equity. Any time you can lower your rate and not lose any equity, it generally makes sense to do so. If it's a long-term mortgage, the "no cost" option will generally cost you more over time than just opting for the lowest rate and paying standard costs.
Q: When should a homeowner consider an adjustable-rate mortgage or ARM?
A: The most popular ARMs carry fixed rates for the first five, seven or 10 years and are based on a 30-year term. Most homeowners choose a 30-year fixed rate loan given their intention to stay in their home long term, though they often fail to consider how long they will hold onto the mortgage. Refinancing occurs for reasons besides lower rates, including removal of mortgage insurance, pulling cash out for home improvements, debt consolidation and combining a first and second mortgage.
Q: When is private mortgage insurance (PMI) required? How can I avoid it?
A: Private mortgage insurance is generally required when less than a 20 percent down payment is made on a home purchase or when the homeowner owes more than 80 percent of the appraised value (less than 20 percent equity) in the case of a refinance. There are multiple ways to deal with PMI. Monthly payments is the most traditional. On conventional loans, which are loans backed by Fannie Mae and Freddie Mac, the monthly PMI drops off automatically when the loan balance equals 78 percent of the original value of the home at the time the mortgage was originated. Homeowners can apply to remove the mortgage insurance sooner if they believe they have achieved 20 percent equity, though those applications are not always approved. Additional options to avoid PMI include paying the mortgage insurance premium in full upfront, accepting a slightly higher rate in lieu of mortgage insurance, or taking two mortgages to avoid PMI.
Q: Should I finance the closing costs in a refinance?
A: Most homeowners choose to roll the closing costs into a refinance to avoid having to pay those costs out of pocket. It's usually a negligible difference in payment to roll the costs in. The main drawback of rolling in closing costs is an increase in your principal balance.
Q: Why do I need to set up escrows for taxes and insurance?
A: When refinancing a mortgage, you'll have settlement charges. There are two separate but distinct categories of settlement charges. The first is closing costs, which are the fees incurred to establish the new mortgage. The second is "pre-paids" or "escrows," which are the moneys put aside upfront to account for future property tax and homeowner's insurance liabilities. When you refinance, you establish a new escrow account for taxes and insurance. Once your old loan is paid off, your existing lender will send you a refund of the balance in your old escrow account approximately 30 days after closing. Keep in mind that you will also skip a mortgage payment in the month immediately following your settlement. For this reason, it is advisable that you bring the moneys required to establish the escrow account on your new loan to settlement if you can afford it.
Q: What should I consider when pulling out cash as part of my refinance? Will doing so cost me more?
A: If you have the equity to do so, pulling cash-out as part of your refinance can be an attractive option to finance home improvements, consolidate high-rate debt, or finance large expenses, such as college or weddings. Depending how deep into your home's equity you borrow, pulling cash-out could negatively impact the rate you can obtain. If pulling some cash out will result in having to accept an elevated rate on your mortgage, you may want to refinance first and then add a home equity line of credit to extract equity from your home.
Q: I want a really low rate for my mortgage. How can I time it so I get the best rate possible?
A: Timing your mortgage lock is like timing the stock market, it's a lost cause. The better approach would be to establish a target rate that justifies the cost of refinancing and then work with a professional that understands the factors that impact mortgage rates daily to monitor that target rate for you and lock if/when it is achieved.
Q: How can I save on my closing costs?
A: You can opt for a slightly higher rate and a "no cost" option (see above). In terms of specific costs, title insurance can be one of the largest costs when refinancing. Most settlement companies will offer a "reissue" rate on your new lender's policy of title insurance when you present the owner's policy of title insurance that you obtained when you purchased your home. This savings can be as much as 30 percent to 40 percent of the premium required for the new policy.
Q: Rates are low. Is it worth it to pay points?
A: Points are essentially an upfront payment of interest in exchange for a lower rate. I'm generally not an advocate of paying points as they add to the sunk costs on a loan and extend your break-even point. Rates are surprisingly low right now. No one predicted they would be where they are and folks who paid points in recent years wasted their money in doing so. Mortgages rarely stay on the books as long as a homeowner thinks they will and paying points further impedes you from taking advantage of lower rates in the future. That said, when considering paying points, the two factors that should be in alignment are that you believe you will keep the mortgage a long time and that rates are at or near historical lows.
Q: Now that I have refinanced and saved money, what should I do with my savings?
A: To really maximize the impact of a refinance, consider redirecting the money you saved into other areas of your financial life. You could expedite your retirement date by adding more to your employer sponsored retirement plan, establish or increase payments to a 529 savings plan for college, put the proper insurance policies in place for you and your family. If you've taken care of all that, you could choose to funnel the savings back into the principal on your new mortgage, pay it down sooner, and save thousands in interest, though of course there may be an opportunity cost in doing so.