Mortgage Refinancing : Should you or shouldn't you?

Interest rates are regulated by each country’s financial institutions. They are lowered during times of recession to encourage economic growth and rises as the economy recovers. Lowered interest rates could be just the financial windfall that you need. It gives you the option of refinancing your mortgage.

You may already be committed to a fixed-rate mortgage of 7 percent. However, you find that your best friend who just got approved for a loan is paying 3.5 percent. Does this mean you should refinance? Or should you stick with the mortgage plan that you have?

First thing’s first. If you are unfamiliar with the vocabulary, mortgage refinancing means that you get a new mortgage loan. In other words, you repeat-finance. You finance your existing mortgage plan all over again, but with an altered payment plan, in this case, with a new interest rate.

The Pros

When interest rates drop, many people with existing fixed-rate mortgages are motivated by the opportunity to snag a lower interest rate and hence reduce their monthly payments. Take for instance, a 30-year $100,000 fixed-rate mortgage refinanced from 9 percent to 4.5 percent will decrease your monthly payment from $804.62 to $506.69.

Small differences in interest rates can thus add up to a huge difference. For example, perhaps your mortgage carries a 4.25 percent interest rate, and newer rates are about 4.00 percent. Although you might think that the difference in the rates are not that big, it’s just one-quarter of a percent anyways, but small amounts can and will compound into huge sums. If you have a 30-year mortgage of $240,000, at the end of it you will have paid roughly an extra $10,000 over the life of the loan compared to the mortgage that is cheaper by a quarter of a percent.

Although clearly, the biggest benefit to sway you to refinance your mortgage is the opportunity to lower your interest rate, which can possible shave thousands off of your total loan repayments, other pros exist. You will also be faced with the opportunity to shorten the term of your mortgage. Even if you maintain the monthly payments without much change, refinancing your mortgage when interest rates fall can significantly lower the term. For example, refinancing a 30-year fixed-rate mortgage on a $100,000 home from 9 percent to 5.5 percent can cut your mortgage term to 15 years, with only a slight change in monthly payment ($804.62 to $817.08).

Refinancing your mortgage also means being able to convert your mortgage from fixed-rate to flexi-rate (or adjustable-rate) and vice-versa.

The Cons

Not all clouds have a silver lining. The main drawback of refinancing? Your mortgage clock will be reset to zero, bringing your amortization schedule back to square one.

To understand amortization, you need to understand how mortgages work. When you make each payment, a percentage of that payment will go towards your interest, and the remaining amount will go towards your original loan principal (i.e. the original amount you borrowed).

When you start a new mortgage, the majority of each payment is an interest expense, and only a little of it goes towards paying off the balance. In the first few years of paying mortgage payments, you will see that you’ve barely paid off your principal balance. As time goes by, more and more of your payment goes towards your principal, and hence you will pay proportionately less in interest for each subsequent payment. By the last few years of your mortgage, almost all of your payments will be applied to paying off your principal.

This process is called amortization, and don’t worry, it doesn’t affect your monthly payment amounts. The math simply works out the ratios of debt and principal payments each month until you end up paying off your mortgage until the last monthly payment, where the total debt is eliminated.

Refinancing your mortgage sets the clock back to year one. This means that you will be starting all over again, and once you refinance your mortgage, your payments will go back to being applied towards interest, not principal.

What should you do?

The general rule of thumb is usually that refinancing is worth the money if you can reduce your interest rate by 2 percent. Some lenders even say that 1 percent in savings is a good enough incentive to refinance. However, you also need to take into account how far into the mortgage you are.

A better rule of thumb is that if you are too far into your mortgage, refinancing may be a terrible deal for you, because you will end up paying more interest than you did under your original mortgage. If you’re within the first few years of your mortgage loan, you should consider it if the reduction in interest rate is significant. Therefore, the earlier you refinance, the better chances you have of getting a deal.

Unfortunately, refinancing does not bring with it an automatic dose of financial prudence. Be aware that you need to look at refinancing as a method of aiding your financial savviness, and not become the source of it. Otherwise, you might be tempted to spend once the refinancing gets saves you money and reduces your debt.

So, don’t assume that refinancing your mortgage is a clear cut good or bad idea. Instead, plug in your interest rate, loan terms and closing costs into an online refinance calculator. Calculate the potential deal that you’re being offered and compare it to the on you already have. Will you be saying money? Will the lowered interest rates be benefical?