In order to discuss and understand what NOT to do when you
are refinancing your mortgage, we should first cover some
basics about mortgages, refinancing, and the reasons why a
person would want to refinance in the first place.
In terms of the actual nature of a mortgage, there is very
little difference between a mortgage and a loan except that
a mortgage is always for a home, it is generally paid back
over a longer period (5-40 years), and the home itself is
used as collateral. Because the real estate that you are
buying is used as collateral, this is what is referred to
as a 'secure loan.'
When a borrower (you) and a lender (usually the bank) agree
upon the terms and time frame of the mortgage, one of the
most important things that is in question is the Interest
Rate (usually cited as an APR percentage, meaning annual
percentage rate). This determines how much the borrower
will eventually pay back to the lender.
The concept behind an interest rate is very simple, and has
been practiced for thousands of years. If Party A lends
money to Party B, and Party B agrees to pay back that money
at a later date, Party B will always pay back MORE than the
total amount borrowed simply because they had the use of
that money over the specific arranged timeframe.
When it comes to refinancing, most people have heard of
this term and possess a general understanding of what it
means. When you refinance your mortgage, you will
generally work with a different lending institution that
agrees to buy out your existing mortgage, and you will then
make payments to this new institution instead of your old
one.
Though the most common reason that a person or family will
want to refinance their mortgage is to take advantage of a
lower interest rate, a few other reasons would be to raise
immediate cash, to lower the TOTAL interest cost, or to
secure against the risk of higher monthly payments in the
future. This last reason, preventing the possible raising
of interest rates, usually amounts to switching from an
adjustable rate mortgage (ARM) to one with a fixed interest
rate.
When a borrower wishes to refinance their mortgage to
obtain immediate cash, this is called 'Cash-Out
Refinancing,' and many people make costly mistakes in this
process which you will learn to prevent below.
-----Mistakes To Avoid With Cash-Out Refinancing----
Cash-out refinancing is borrowing more than the total cost
of your home in order to have a chunk of cash left over
after you have repaid your existing mortgage.
If you are looking to get some cash to work with using a
mortgage, this simply means that you are getting a loan
based on the value of your home, with the home itself as
collateral. You have two options when it comes to this, and
which one you should use pretty much depends solely on the
interest rates available to you. You can either work with a
new bank and let them know that you want the value of your
new mortgage to be HIGHER than the value of your old one,
or you can obtain a second mortgage.
Now when most people hear about taking a second mortgage
out, their brain tells them that they must avoid this at
all costs as it may put them further in debt. But this is
not always right, because usually with cash-out refinancing
the bank or lender will charge you a higher interest rate
than if the value of your new mortgage was THE SAME as your
old one.
For simplicity's sake, let's us easy numbers in this
example: The existing value to be repaid on your mortgage
is $200K, and you need $20K cash for something like a
hospital bill (or maybe a generous donation to your
Tropical Vacation trust fund). You can refinance your
mortgage at $220K at 7%, or you can obtain a second
mortgage of $20K at 12%.
Which one is better? Most people would say that
refinancing in this case would be better, because they are
conditioned to think that a second mortgage is an indicator
of poor financial health, and also they are scared off by
the higher interest rate. But the total interest that you
would pay on the second mortgage in this example is far
LESS than what you would end up paying for the refinanced
mortgage.
----A Common Mistake When Refinancing For Lower Interest
Rates----
Everybody should agree that it makes sense to refinance
your mortgage if you are able to secure a lower interest
rate, but at what point does this strategy become
profitable?
When most people go about trying to find the answer to this
question, the two things that they compare are only their
current interest rate and the interest rate they will get
if they refinance. The one thing that they will often
forget, and the thing that you now know to take into
account, is the COST that the new bank or lending
institution will charge for the refinancing.
Depending on the bank, the current prevailing interest
rate, and the amount of the mortgage, this cost can
sometimes be large to the point that it will actually
negate the money that you save from the lower interest rate!
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