Why Should I Refinance?

There are many reasons to consider a mortgage refinancing. In today’s American culture, many reasons given are inappropriate; some reasons are useful and cannot be dismissed.

In general, refinancing a mortgage is done to accomplish one or more generic goals. These include: improvement the interest rate currently being borne under the old mortgage, shortening the term (years to go until the loan is paid off) or to “cash out” some of the equity (the excess of market value over the mortgage debt) that has been built up in the property. Any one of these reasons is salutary, and should be done if the numbers indicate an economic advantage to do so.

In truth, refinancing for rate usually means a change in term. Therefore, such a transaction is widely known as a “rate and term” refinance. Rate and term can be combined with a “cash out” transaction, so long as there is enough equity in the property to permit the lending of additional money.

Here’s an example:
In 1990 Jon and Alice purchased a new home for $100,000, paid down $20,000 and took a 30-year mortgage for $80,000.

At that time, they were able to get an interest rate of 8.75%. Their mortgage payment on that loan was $629.36 per month for 360 months (principal and interest – also known as P&I) .

Now, in 2004, they find that their home is now worth $290,000 and that the remaining balance they owe on the old mortgage is only $64,920. The house being worth $290,000, minus the balance on the mortgage of $64,920, they are delighted to realize that their original $20,000 equity is now worth $225,080!

Jon and Alice speak to their mortgage broker and discover that they now can refinance the remaining balance at 5.875% and reduce their payment to $384.03 per month.
They are excited with the improvement, but also discover that the amortization period (the number of years it will take to pay off the loan) gets reset to 30 years.

A little concerned, they call the mortgage broker again and find out that by doing the refinance anyway, they will save $58,431 in interest over the next 30 years compared to the remaining interest that will be owed on the old loan. “Now that’s better,” agrees Alice.

So, what have we learned? Refinancing can be very helpful.

A word of caution: A mortgage loan is a long-term obligation.

Common sense would tell us to use it for a long-term purpose. Like buying a home.
In our example, Jon and Alice have been fortunate and their equity has grown dramatically over the years. They can now borrow some of their equity for a suitable reason. Like a remodeling or building a swimming pool. And, as long as they are refinancing for rate and term, they might take this opportunity to borrow some of their equity to cover the expense of such a project.

A word of caution: In most cases, the bank will not ask why you are borrowing the extra money in a “cash out” loan.

The bank already has the collateral they need, a lien on your home. You must rely upon your own good sense to act appropriately.

Here are some examples of bad uses of home equity:
Investing in the stock market
Buying a car
Going on vacation
Using home equity for current living expenses

Here are some examples of good uses of home equity:
Substantial home improvement projects
Investing in an established self-owned business
Higher education expenses
The choice will be yours. Borrow wisely.