If you’re carrying a mortgage on your home, you’re probably acutely aware of prevailing interest rates, how much you’re paying, and the dent it leaves in your bank account every month. With advertised rates so low now, it might even seem like you’re paying too much. Is it a good idea to break your current mortgage and refinance at the lower rates?
The mortgage refinancing decision is a complex one and really becomes a numbers game. This question is not unusual, and is one of the most common questions clients ask me.
There can be a number of reasons for thinking about refinancing your mortgage. Searching for a lower interest cost is in fact the reason most homeowners refinance. If you’ve built up equity, you might also be considering borrowing against some of that equity and reinvesting in assets that might produce a higher yield. Or you might be looking at consolidating existing mortgage loans – say, a home equity line of credit (many people mistakenly believe that this is not a “mortgage,” but it is) – into one mortgage at a lower rate. Other people want to change to a variable-rate mortgage (or to a fixed-rate mortgage).
Whatever the reason, it’s important to do some number-crunching (or have someone do it for you!). Mortgage refinancing might seem to be the answer to your home-ownership prayers, but without some serious analysis, you could end up driving over your personal “fiscal cliff”. You might, for example, inadvertently take on more debt than you wanted, or become trapped in a mortgage structure you don’t fully understand.
So before you jump into a mortgage refinancing, there are a number of important points to keep in mind.
The penalty box
First and foremost, you will pay a penalty for prepaying your current mortgage before term. The penalty for most closed, fixed-rate mortgages is typically either a straight three months of interest or something called the interest rate differential penalty (IRD). The IRD is basically calculated as the difference between your original mortgage rate and the rate that the lender can charge today on lending the funds out again. Refinancing a variable-rate mortgage incurs a straight three-month interest penalty.
Then, of course, there are those legal fees, which for many mortgagors looking to refinance come as a surprise. However, remember that any change in financing on your home must be listed on the title to your property, and this change must be done by a lawyer. Those costs can add up. For larger mortgages, the lender may often absorb the legal costs in a refinancing, but this depends on the lender and whether you have a good previous relationship.
Break out the calculators!
Next comes the number-crunching. Once you’ve figured the costs of refinancing, including the interest penalty and legal fees, you’ll have to compare whether the interest payments you save by refinancing are greater than the combined penalties and fees you’ll pay for a mortgage of the same term. If you have only a short time left on the term of your mortgage, it probably doesn’t make sense. If you have a longer-term mortgage, look at a difference in rates between your current mortgage and your proposed refinancing. A difference of more than one percentage point over, say, a 10-year term may be worth the effort, depending on the size of your principal of course.
Mortgages are complicated debt instruments with very strict financial and legal obligations. Sometimes refinancing at a lower rate or for other reasons can make financial sense – but there are no easy answers. It boils down to dollars and cents. If you’re in doubt about whether a refinancing makes sense for you, check with your financial advisor. In my own planning practice, I help clients make their mortgage calculations accurately, and let you know whether the move would be financially beneficial within the context of your overall financial plan. That way, you’ll be able to apply the brakes if you appear to be driving off the proverbial “fiscal cliff.”