This is a question you may have asked yourself recently, especially with interest rates being at
record lows. Before we get into it, let’s go over some basics. When you purchase real estate
(such as a home, a commercial property, or even a business), unless you pay the total purchase
price in cash, you will need to have some amount of the purchase financed. Your down payment
and the financing you get will make up the purchase price. The financing from the bank will
usually be in the form of a 15 or a 30 year loan that’s charging you interest. For all practical
purposes, the loan will either be a fixed-rate mortgage, meaning your interest rate is locked in,
or an adjustable-rate mortgage, where your interest rate actually adjusts with the current rates.
To keep things simple, we’ll mainly be looking at fixed-rate mortgages. First of all, as you make
your monthly payments, you are paying your principal (debt from money you borrowed) and
interest (the cost of borrowing the money) on the loan. In the beginning, most of your monthly
payment goes toward your interest payment, but as you progress through the life of the loan, the
tides turn and more of your monthly payment goes toward your principal and less towards your
interest.
As a quick example, your loan is $115,000 at 5% interest for 30 years and the monthly payment
(only accounting for principal and interest for the sake of the example) is $617/month. At 5%
interest, we get ($115,000 x 0.05) $5,750 per year. Per month, your interest alone will be
(5,750/12) $479.17. If we take this from the monthly payment of $617, we get $137.83. This
$137.83 represents the amount of the principal paid off in that first month. The principal balance
at the start of the second month will now be (115,000-137.83) $114,862.17. If you do the
calculations, you’ll find that in the second month, you’ve now put $138.41 towards the principal.
The interest rate doesn’t change and the monthly payment doesn’t change. At the same time, the
principal balance is decreasing so the amount of interest paid in each subsequent monthly
payment will be gradually smaller. Meanwhile, the amount of that monthly payment going
towards the principal balance of the loan will increase. This is important to note because with a
lowered interest rate, you will be paying more of the principal with each payment and less
interest.
The more you can chip away at the principal of the loan, the quicker you will build equity in
your home. Before diving into the pros and cons of refinancing your loan, we need to define it.
When you refinance your loan, you are replacing it with a new loan. It’s really as simple as that.
Specifically, you’re taking a new loan and paying off the old loan.
The Pros of Refinancing
Now, the whole point of refinancing the loan on your home is to get a lower interest rate. You
can do a few different things when refinancing. If you want to pay off your mortgage quicker,
you can switch from a 30 year term to a 15 year term to pay off the debt. Depending on the
refinancing terms, you could be looking at a very similar and (possibly lower) monthly payment
only with a loan term that’s cut in half. This could potentially save you tens of thousands of
dollars in interest payments during the life of the loan. Additionally, a lower interest rate could
result in a much lower monthly payment, meaning potential additional savings of several
hundred dollars per month with a new 30 year term.
Another benefit to either option would be building equity in your home building much quicker.
Taking the same example from before, we’ll change the interest rate from 5% to 3.375%, and
leave everything the same. If you run the numbers, you’ll find that the payment towards the
principal for the first month would be $293.56. This is compared to the $137.83 put towards the
principal in the first month when the interest rate was 5%.
Furthermore, you can refinance the loan in a way that lets you access the equity in your home.
This is called a cash-out refinance. For example, if you own a home that is worth $300,000 and
you owe $150,000 on the mortgage, you have $150,000 in equity. By leveraging the equity in
your home, with a cash-out refinance, you could take a loan of $200,000, for example. $150,000
would pay off the old loan and you would have $50,000 in cash to do with as you please.
However, that’s usually the problem. You should only ever do this to pull out additional funds
that are absolutely necessary. Over-borrowing is a common problem in a cash-out refinance.
However, when done responsibly, it’s a good way to access your equity to cover any debts or
obligations you have or to even increase the value of your home.
The final reason to refinance is to convert your current loan to a new type. For example, if you
have an adjustable-rate mortgage, you could convert it to a fixed-rate to maintain a low interest
rate and keep it stable for the remainder of the loan term.
The Cons of Refinancing
Refinancing is not optimal for every loan situation, however. When closing on the new loan, you
could be looking at closing costs of anywhere from 2% to as high as 6% of the new loan amount.
Even if you get a great new rate, it may not be worth it depending on the size of the loan, the
remaining life of the initial loan, and how long you plan on staying in your home. In many cases
it can take several years to recoup closing costs. Also, with it being an entirely new loan, this
will have a new term of 15 or 30 years in most cases. Most people don’t want to extend the time
they have to wait to own their home free and clear, even though their payments are lower.
Conclusion
Experts say it’s worth it to refinance if you can get your interest rate lowered by at least 1%. Of
course, it also depends on the life of the loan, your rate vs. the current rate, your financial
situation and goals, the loan terms, and how long you plan on staying in the home. As always,
the answer to the big question depends on you. We’re just hoping to shed some light on the topic
so you can have some knowledge before you dive into your options with a professional.
Remember, for all of your real estate and business brokerage needs, Apex is here to help.
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