When you are trying to decide whether or not to refinance your mortgage, you have to take a lot of things into account to make an intelligent decision. There are many variables at play, and a misstep could cost you lots of money.
The reason you ask a lending institution for a mortgage is because you don’t have the full asking price for a piece of property. The lender gives you the money because it feels that you are creditworthy, meaning, that you will pay back the money you are loaned plus interest in the agreed upon amount of time. That’s the commitment you make when you sign on the dotted line.
You also make an educated bet when you agree to the loan terms. You assume that because the monthly payment amount is appropriate for your current financial situation, you will be able to keep up those payments over the life of the loan, and not fall delinquent.
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Many homeowners consider refinancing because they can no longer keep up the payments. One of the reasons for this is that you may have initially chosen an adjustable rate mortgage (ARM). The interest rates on these loans changes periodically, usually in relation to the changes in the interest rates of an index.
The interest rate and monthly payment most commonly change every year, 3 years, or 5 years. Lenders base ARM rates on a number of indexes, including the rates on 1-year constant-maturity Treasury securities, the Cost of Funds Index, and the London Interbank Offered Rate.
These types of mortgages are generally attractive because the introductory, or “teaser” rate, is usually a few points below a fixed-rate mortgage. There is the possibility that an ARM could be less expensive over a long period than a fixed-rate mortgage if interest rates remain the same as when you took out the loan, or if they should go lower.
However, there is always the risk that interest rates will rise, making the payments higher than you can afford. That’s when homeowners look to refinance to a fixed-rate mortgage.
Unlike ARMs, the interest rate on a fixed-rate loan isn’t tied to an index, so it remains the same throughout the life of the loan. That means each month you know exactly what your mortgage payment will be for as long as you have the loan.
So if the interest rate on an ARM fluctuates, does that mean that you should always avoid it in favor of a fixed-rate mortgage? The answer to that question is “no.” Adjustable rate mortgages are a good idea if you plan to stay in your house for less than five years. In that case, you can get an ARM that lets you keep the low initial rate for the first five years of the loan, and then adjusts every year there after. The money you save by paying lower rates can be used to increase your savings.
On the other hand, if you plan on owning your home for more than five years, a fixed-rate mortgage may be the better option. You will be protected from sudden and possibly drastic increases in your monthly mortgage payments if interest rates rise. In addition, knowing what your monthly payment will be makes it easier to budget for it. The biggest disadvantage to a fixed-rate loan is that when rates drop you are locked into the rate you agreed to initially.
Regardless of the type of loan you had at the time you purchased your home, there still may be some good reasons to refinance:
Lower your interest rates -- If you take out a new loan with a lower interest rate, you decrease your monthly payments, and you also lessen the total amount you pay over the life of the loan.
Build up equity quicker -- If you refinance to a mortgage with a shorter term, you pay off your loan faster, which means you build up equity in your home at a faster pace.
Take cash out of your home -- If you have already built up equity in your home, then you can refinance for more than you currently owe and take that additional amount out in cash. This is called a cash-out refinance.
Pay off debt -- If you have a lot of high interest credit card debt, you may want to refinance your home and take cash out to pay off the debt. The difference between the interest rate on your credit cards and your mortgage can be substantial, and you will save money by paying the lower mortgage rate.