See Also: When (and when not) to refinance your mortgage
Refinancing a mortgage means paying off an existing loan and replacing it with a new one. There are many reasons why homeowners refinance: the opportunity to obtain a lower interest rate; the chance to shorten the term of their mortgage; the desire to convert from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage, or vice versa; the opportunity to tap a home's equity in order to finance a large purchase; and the desire to consolidate debt.
Some of these motivations have benefits and pitfalls. And because refinancing can cost 3% to 6% of the loan's principal and – like taking out the original mortgage – requires appraisal, title search and application fees, it's important for a homeowner to determine whether his or her reason for refinancing offers a true benefit.
Securing a Lower Interest Rate
One of the best reasons to refinance is to lower the interest rate on your existing loan. Historically, the rule of thumb was that it was worth the money to refinance if you could reduce your interest rate by at least 2%. Today, many lenders say 1% savings is enough of an incentive to refinance.
Reducing your interest rate not only helps you save money, it also increases the rate at which you build equity in your home, and it can decrease the size of your monthly payment. For example, a 30-year fixed-rate mortgage with an interest rate of 9% on a $100,000 home has a principal and interest payment of $804.62. That same loan at 4.5% reduces your payment to $506.69.
Shortening the Loan's Term
When interest rates fall, homeowners often have the opportunity to refinance an existing loan for another loan that, without much change in the monthly payment, has a significantly shorter term. For that 30-year fixed-rate mortgage on a $100,000 home, refinancing from 9.0% to $5.5% can let you cut the term in half to 15 years, with only a slight change in the monthly payment from $804.62 to $817.08.
Converting Between Adjustable-Rate and Fixed-Rate Mortgages
While ARMs often start out offering lower rates than fixed-rate mortgages, periodic adjustments can result in rate increases that are higher than the rate available through a fixed-rate mortgage. When this occurs, converting to a fixed-rate mortgage results in a lower interest rate and eliminates concern over future interest-rate hikes.
Source By: INVESTOPEDIA
