Timing Your Refinance

With mortgage rates at historic lows, now may be the perfect time to consider refinancing your home loans. Refinancing can lower your interest rate, decrease your monthly payments or provide you with money for major expenses.

In the wake of the housing crisis, mortgage rates have plummeted to historic lows as financial institutions and the Federal government attempt to get the market back on track.

To take advantage of low interest rates, now is the perfect time to consider refinancing your mortgage. Refinancing replaces your current mortgage with a new one and can allow you to lower your mortgage payments, save on interest or tap into your home’s equity.

“These are unprecedented times,” says Mike Pallares, Vice President, Mortgage Divisional Manager for First Midwest Bank. “We’re seeing rates in many different categories at all-time lows.”

But before you rush to refinance, you should consider the options available to you with the help of your First Midwest Banker to determine which loan may be the right choice.

Rate and Term Refinance

Rate and term mortgage refinances are ideal for those looking to lower the interest rate or reduce the term on their current mortgage, Pallares says. Lowering the interest rate decreases the monthly payment on the mortgage, and reducing the term could allow homeowners to save on interest over the length of the mortgage.

Rate and term refinances are also ideal for those who want to go from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage, Pallares says. With an ARM, the interest rate is fixed for a brief period, usually for three to five years. After the fixed period, the mortgage adjusts according to current market rates and the terms of the note.

Although ARMs may be ideal for homeowners who plan on staying in their home for a limited amount of time, an adjustable rate requires a home reappraisal and can result in unpredictable monthly payments, Pallares says. A fixed-rate mortgage provides consistency and peace of mind, he adds.

“Although an ARM can provide a lower rate, it’s offset by the risk of it increasing when it has to reset,” Pallares says. “In the low interest rate environment we’re in now, people should look at a 30- year or a 15-year where it’s going to be fixed for the duration of the mortgage.”

On the other hand, a homeowner who already has a 30-year mortgage and decides to refinance to another 30-year fixed mortgage could end up paying more interest by extending the length of the loan, Pallares says.

To avoid this problem, homeowners may want to select a shorter term, such as a 10-, 15- or 20-year mortgage. Most financial institutions allow the homeowner to make additional payments to reduce the principal balance without committing to a shorter term. Shortening the term of a mortgage builds equity in a home more quickly because homeowners pay less interest and allows the loan to be paid off sooner, Pallares says. But he warns shorter terms could also increase monthly payments, depending on the rate environment.

“You may not want to shorten the term of the loan if you’re not planning on staying in the home for a large duration of the loan,” he says.

Cash-Out Refinance

A cash-out refinance is a helpful option for those who need to consolidate debt or free up funds for home improvements or other major expenses.

Like the rate and term refinance, homeowners may be able to lower their interest rate to lower monthly payments or switch from an ARM to a fixed-rate mortgage. But unlike the rate and term refinance, cash-out refinances allow homeowners to take additional equity out of the house to use it for purposes like paying off credit card debt or car payments or remodeling a home, says John Thomas, Certified Mortgage Planner with Primary Residential Mortgage in Newcastle, DE.

“You can have the benefits of the rate and term in the cash-out,” Thomas says.

Because cash-out refinances are currently at low interest rates, this option is preferable to taking out a home equity loan or a second mortgage if the interest rate is the same or lower than the rate on a current mortgage, Pallares says.

“If a person is able to stay at the same rate, take cash-out or get a lower rate, now’s a very good time in this low-rate environment to do that, rather than dip into savings or take out a home equity loan,” he says.

And an added benefit is that homeowners can deduct the interest1 they pay on the mortgage, allowing them to save even more money, Pallares says.

At the same time, homeowners must be aware that they run the risk of paying more interest overall by extending the period of the loan.

Reverse Mortgages

Some individuals can refinance their homes with reverse mortgages, which eliminates mortgage payments for the duration of time the person is in the home, Pallares says.

To qualify, a person must be 62 years old or older, and there is no need to meet any credit score or income requirements like the traditional mortgage refinance. The amount of equity in the home and the size of the loan required will also affect your qualifications. Pallares says the mortgage is paid off upon the sale of the home or when it passes to the homeowner’s estate.

Before You Refinance

To determine whether you can afford to refinance, you should take into account the interest rate, the size and term of the loan and the closing costs on your loan.

Although a good rule of thumb is to refinance only if the rate on the new loan is 1.5% to 2% lower than the rate on a current mortgage, Pallares says a better indicator is determining the break-even point on closing costs, or the costs that must be paid at the time of closing on a loan. The simplest way to do this is to divide the cost of closing by the monthly savings on your new mortgage to determine the amount of months it takes to break even.

Thomas says mortgage lenders or brokers can provide a good-faith estimate, which predicts the closing costs on a mortgage. This helps clients determine whether refinancing is feasible.

Maintaining a Stable Equity Cushion

If you decide to refinance, you’ll want to maintain a stable equity cushion to prevent owing more on your house than it’s worth, should the value of your house decrease.

Pallares says First Midwest Bank first mortgages are typically underwritten at an 80% loan to value rate, meaning the bank will lend clients up to 80% of the value of a home. The remaining 20% provides a stable cushion in a refinance period where the purchaser or borrower would need to come up with a 20% down payment.

“By originating your mortgage at 80%, you allow for future extraction of equity,” Pallares says. “You also build in a cushion in case you need to when the market has decreased, so you’re not upside down or find yourself owing much more than the amount of your loan when you go to sell your house.”

Thomas also recommends that homeowners maintain a six-month emergency reserve in a savings account rather than building additional equity. That way you can avoid taking out a loan if an unexpected expense occurs.

“It’s more important to make sure you’ve got a liquid cash reserve outside your house before you worry about how much equity is in your house,” he says. “Instead of throwing money into your mortgage, throw it into your savings account.”

Predicting Future Interest Rates

You may wonder whether or not you should take advantage of low interest rates now or wait to see if they drop.

There’s some indication they could rise in the first or second quarter of 2010 after the federal government stops buying mortgage-backed securities and treasury bonds, Thomas says.

But Pallares adds that it’s difficult to determine future rates. “For all intended purposes we’re seeing in many different areas – product wise and in different regional areas – an all-time low. No one really has that crystal ball.”

Regardless of what rates may be in the future, there’s no doubt now is the time to consider refinancing, Thomas says.

“We’re probably not going to see rates this low anytime soon,” Thomas says. “Now is the time to get the analysis to see if it makes sense.”

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