Refinancing your mortgage: It’s not just about the rate
These are truly remarkable times in the mortgage industry. Mortgage rates are still at their lowest point in more than 50 years presenting homeowners with a once-in-a lifetime opportunity to lock in rates while they’re at or near the bottom. No one can say for certain whether rates can or will drop even further, but what is certain is that, at some point, they will go up. On the other side of the equation, there are fewer homeowners who can qualify for the lowest rates due to the erosion of home equity or, perhaps, some credit issues that arose during the economic downturn. However, if you have equity in your home and you escaped the recession unscathed, there may be no better time to refinance your mortgage.
Should You Refinance?
Unquestionably, declining interest rates are the primary impetus for refinancing a mortgage, but there are other considerations that go into determining if it will actually make sense for you in the long run. Lower rates don’t always translate into lower overall costs. When you refinance, your loan amortization begins anew, and your new payments will once again be top loaded with interest as oppose to principal. It is important to consider your long term goals and outlook; otherwise you could find yourself increasing your long-term costs. There are really just three sound justifications for refinancing at any time:
- It will lower your monthly payment: while that may be true, you still need to calculate the long-term impact on the total cost of ownership. If the total interest you will be paying on the new mortgage is more than what you would have paid under your existing mortgage, you haven’t improved your situation. While some people need to lower their monthly payment out of necessity, those who can afford their current mortgage payment may be better off because they’re further ahead on the principal portion of their amortization. Also, if you don’t plan on keeping your home for at least ten years, you may not make up the additional cost of loan fees. Generally, if you can’t lower your rate by at least one point, your break even will be longer than ten years.
- It will shorten your loan term: the best way to take advantage of historically low mortgage rates is refinance into a shorter loan. Shorter term mortgages usually carry mortgage rates a half point below the standard 30 year mortgage. It could be a great opportunity to pay off your mortgage early so you can redeploy your cash flow to savings. It’s important to consider that, because the length of the mortgage is shorter, your monthly payments may be higher due to the acceleration of principal payments. As an alternative, you could apply your excess cash flow to your principle on your existing mortgage and have the similar effect of paying off your mortgage early.
- You need to cash out some equity: if you are in a solid equity position in your home, a cash-out equity refinance can give you access to the equity, if you truly feel you have a better use for it. Generally, a cash-out refinance is done through a home equity loan or line-of-credit. This is risky on two fronts: firstly, if the market in your area is still somewhat volatile you could risk a decline in your remaining equity; secondly, if you take out a home equity line of credit, your variable rate could increase as interest rates increase. It’s strongly recommended that you be able to maintain at least a 10 per cent equity position in your home after the refinance.
Generally, you should consider a refinance when, considering short and long-term costs and savings, you can markedly improve your financial situation.
How to get the lowest rate
Just because a lender is offering the lowest possible rate doesn’t mean they’ll actually give it you. Typically, lenders reserve their best possible rates for the most credit worthy borrowers – those with sterling credit histories, 800-plus scores, low debt-income ratios, etc. So, unless you are in that category you could wind up with a higher rate which could blow your cost/savings calculations out the window. You need to know where you stand before you apply. Your lender should be able to give you an indication of your standing before you get deep into the application process, but you won’t know the exact rate you qualify for until you apply and are approved. To better your chances of obtaining the best rate you will need to:
- Work on increasing your credit score. The difference between a score of 780 and 800 could be a half to three-quarters of a point.
- Lower your debt-income ratio. You can get approved with a debt-income ratio of 38 per cent, but, if you want to attract the lowest rates, get it down below 31 per cent; by paying off debt, or increase your income.
- Make sure your loan-to-value (LTV) is at least 10 per cent after the refinance. This is where you have the least amount of control. If home values are on the rebound, you may just have to wait. Some banks may be willing to refinance at higher LTV, but they will likely charge higher rates to do so.
Finally, check out the community and regional banks in your area. They are very willing to compete for your business, and they are always enthusiastic about beating the big banks. Plus, they are more likely to underwrite your loan locally which means more responsiveness and quicker turnaround time.
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