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In the past few years of refinancing boom, millions of home owners have taken advantage of low rates and refinances their mortgage. The purpose of this article is to discuss the advantages and pitfalls associated with a refinance (a.k.a. refi) loan.

Home refinancing 101

In recent years, Americans have taken good advantage of lower interest rate refinance loans and refinanced their mortgages. Refinancing was at its peak in 2003. However, 2004 and 2005 were not bad years either according to Mortgage Bankers Association of America.

While it is true that refinancing your home loan can help reduce monthly payments, the refinancing strategy might not always make sense in every situation. So before you jump into refinancing your home, take a step back, do your due diligence and determine whether refinance will be the right move for you.

To refinance or not

The rule of thumb states that refinance your home mortgage if the new interest rate being offered on your mortgage is at least 2 percent points lower than your current mortgage interest rate for example, from 8% to 6%. But a more important consideration is, how long do you intend to carry the mortgage, and do you intend to stay in your current home that long. In other words, make sure that the savings in refinance will compensate the cost of refinancing your home mortgage.

To gain a better perspective on refinancing, lets consider an example. If you had a $200,000 30-year mortgage and your current interest rate is 8%, your monthly payment will be $1,468. If you get a refinance interest rate of 6%, your new monthly mortgage payment will be $1,199. This will result in a saving of $269 per month. Lets assume that your refinancing cost is around $2,000, it will take you eight months to break even - $269 x 8 = $2,152. If you plan on staying in your current home for more than 8 months, refinance might seem to be a viable option. However, if you plan on selling your home, you might want to avoid refinancing.

Look beyond the APR for mortgages

There are several factors to be considered before refinancing, not just the annual percentage rate (APR). Lets consider these factors:

Term of the mortgage - Term of the mortgage is the amount of time it takes to pay off the principal and the interest. Short-term mortgages are tailored to offer lower interest rates compared to long-term mortgages. However, short term mortgages involve higher monthly payments. They also offer the potential to significantly reduce the interest costs since you are paying interest for a considerable less number of years.

Variability of interest rate: Mortgages can be broadly classified into fixed and variable interest rate mortgages. As the name suggests, fixed interest rate mortgages have an unchanging interest rate for the life of the mortgage. However, a variable mortgage rate can change after a pre-determined amount of time such as 1 year or 2 years. The adjustable rate mortgage (a.k.a. ARM) offers low introductory rate compared to fixed rate mortgage, but the interest rate on the ARM will rise in future as interest rates go up. If you intend to stay in your current home for a long time, it simply makes sense to opt for a fixed rate mortgage. This mortgage is also good for your budgeting purposes and projecting mortgage payments in the future. An adjustable rate mortgage makes sense if you intend to sell the property in the next few months or you intend to pay off before interest rate start to go up.

Points - Points are also referred to as origination fees or discount fees. These are the fees you pay the bank or credit union when you close the deal. While a zero point or no cost mortgage does not carry this upfront cost, it could prove expensive to you if the bank charges higher interest rate instead. What you have to determine here is whether saving from lower rate justify the costs of paying points. One point is equal to 1% of the loan. A bank official can calculate and help you determine whether you should or shouldn't be going with points at all.

Are you really ready for a new lender?

Your current lender may be able to provide you with a refinance loan much easier and possibly cheaper than a different lender. In part, since most of your paperwork and important documents already exist with your current lender, you may be able go through the refinance process much faster. However, if it is time to move on, shop around, ask the right questions and pull out your calculator and crunch the numbers.

Summary on home refinancing

• Refinancing should be considered if long term savings outweigh the initial expenses. Find the number of months you will need to stay in your current residence for the refinance strategy to work in your favour.
• Do not select a home mortgage simply based on the Annual percent rate (APR).
• Evaluate other measures like term of the refinance loan, fixed or variable interest rates, merits of points.
• Your current bank or lender has all your financial information and may be able to offer you a competitive refinance loan and you may be able to avoid a new lender.
• To get the best refinance loan, shop online and off, ask lots of questions and do some calculations or ask the bank to do the calculations for you.

Refinance checklist

• Do a thorough and focused study on which mortgage offers you the best benefits.
• Read the contract thoroughly before signing.
• If refinancing saves you money, use the savings for important goals like saving for your retirement or putting your kids through college.

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