5 Reasons for Refinancing

August 20, 2010

Author: William M. Davis

The dream of buying your own home, repaying it as soon as possible and living out your retirement is one which is not as applicable as it was to your parents or to their parents, who probably lived through the Great Depression when security in property meant security for your family. However, we have lived through our own economic crisis and we still are and it is important to learn the lessons relevant to our generation and our property needs.

Repaying your home as fast as possible doesn’t always make the best financial sense. Often cash flow, capital growth and freedom from debt are more important in maintaining stability and security for your family, than owning your home outright right now. Therefore, consider the top five reasons people refinance their homes, and how you can use mortgage refinancing to set your family up with the modern version of security through property.

1 Debt consolidation

The reality is that most of us have a credit card or two with an outstanding balance we just can’t shift. One of the greatest barriers to getting rid of any sort of personal debt – credit cards, personal loan, store cards or student loans – is the interest rate, and the compounding interest which just keeps being added to your balance and increasing your repayments.

As a result, consolidating debts into your home loan is a popular reason for refinancing because home loans are the form of borrowing with one of the lowest interest rates. To refinance your loan to consolidate debts you will need to be able to show your lender capital growth, and an accumulation of equity which you can borrow against. Your principal loan amount can then be refinanced, subject to approval as your borrowing capacity will be reassessed, to include your existing home loan amount, plus the amount of equity you need to access to repay your other personal debts.

Debt consolidation is only a good reason to refinance if you keep your consolidated debts and your original home loan amount split, so you can still focus on repaying your personal debts sooner; if you don’t you will end up paying more interest on your personal debts because you are paying them off over a much longer term.

2 Lower repayments

Lower mortgage repayments can ease the pressure on your cash flow situation and free up funds for other investments, lifestyle changes such as a holiday or a private school for your child, or to direct more funds to your 401K for your retirement.

If your refinance your home loan to one with a lower interest rate, even a discount of half or three quarters of a percentage point can lower your monthly commitments. However, for this to be of a true benefit, you need to make sure you plan to stay in your home and keep your new loan for long enough that you break even – that is, the costs of refinancing are outweighed by the savings you have made.

If you can’t find a better interest rate deal you can choose to lower your repayments by refinancing your loan to a longer term. If you have a loan with a 15 or 20 year term, refinancing to a loan which spreads your repayments over 30 years can reduce your monthly commitment. Just make sure that in 30 years you will still be able to cover your repayments, and that you’re not heading for retirement and a reduced income.

You can also make lower repayments by making interest only repayments on your loan. This type of refinancing can also be one of the most affordable as you can often change your repayment structure with your existing lender. Therefore, instead of paying the interest and a portion of your principal each month, you are paying just the interest which has accumulated. Keep in mind this doesn’t reduce your loan amount and your repayments may go up at the end of an interest only period – usually up to 10 or 15 years – to keep your principal repayment on track within the term of your loan.

3 Refinance for a different type of interest rate

Choosing a fixed interest rate to see you through the term of your loan can be restrictive, especially if interest rate have dropped, or you’re able to pay more off your loan but can’t with a fixed rate product. Therefore, you may consider switching to a fixed-period adjustable rate mortgage (ARM) which is also known as a hybrid ARM. These loans will give you both a fixed and an adjustable rate on your mortgage, where a 3/1 ARM for example would have a three year fixed rate and would adjust once a year after that. Plus, the fixed interest rate for the initial period is lower than the fixed rate on a 15 or 30 year fixed mortgage so you are saving money from the beginning.

4 Cash out refinancing

While you can access the equity in your home to repay personal debts, you can also use cash out refinancing for whatever you choose. The equity in your home is the difference between the value of the home and the amount remaining on your loan. You can apply to refinance and access that equity in a lump sum payment for a new car or a family holiday.

Alternatively you can refinance to a home equity line of credit and have your loan amount approved up to your available equity amount, and draw down on those preapproved funds when you choose, for a home renovation, a party or to pay unexpected bills. With a line of credit you don’t have to make repayments until you have reached the limit of available credit, and you are only accumulating interest on the amount of the credit you have used.

5 New loan features

When you took out your loan, the features of the product may have been perfect for you. However, lenders are always making changes to the features offered and the loan structures used, that there may be a better way to structure your loan.

For example, if you took advantage of a balloon program when you applied for your home loan, you would have received lower interest rates and lower initial repayments. However, if you are still living in your home at the end of the fixed rate term – which you may have chosen from 5-7 years – your entire mortgage amount is now payable. Luckily, you can easily refinance to a new adjustable rate mortgage, or a new fixed rate mortgage.

Or, if you didn’t provide a deposit when you applied for your loan you will have been able to secure your dream home without using funds of your own, but you would have paid private mortgage insurance (PMI) because you purchased your home with less than 20% down. The PMI you are paying protects your lender if you default on your loan but if you have been repaying your mortgage for some time, the value of your home has increased and your loan amount has decreased, so by refinancing you may be eligible to remove the PMI costs from your loan as you can provide that equity as security.