Taking on a mortgage can often be a very expensive affair. In fact, a lot of times, simply paying back the mortgage capital and the interest itself, takes up a lot of one’s monthly income, thereby leaving very little for other expenditure. On the other hand, looking at it from a more long term perspective, taking a mortgage also gives one the security of a home. With banks and money lenders eager to be ahead of everybody else in the mortgage market, it often proves advantageous for the borrower.
Since life itself is very unpredictable, there may come bigger expenses to take care of along with a mortgage payment. Which is why, there is now the provision of taking a second mortgage, so as to have an immediate source of cash at one’s disposal.
Although it now means paying off two loans, with possibly varying interest rates, a situation of not having any ready money has been averted. Mortgage refinancing works on almost the same lines. Refinancing is simply defined as taking on a new debt or equity and sometimes a combination of both to restructure an existing debt. Refinancing is usually done by a borrower during a period of declining interest rates so that the average cost of the debt can also decrease. This especially proves to be favorable for people who are paying too high an interest on their current property. At times, refinancing involves issuing equity so as to reduce the proportion of debt of the borrower. Refinancing allows the flexibility of allowing the extension or reduction of the maturity of the debt. Secondly the new debt may carry a lower interest rate also.
Owners of homes need to think carefully about any decision they make with regards to refinancing. Two important questions that should be asked are whether it is the right time to refinance and secondly what is the security that should be used for refinancing. In most cases it would simply be the house you are living in. However, there is a general theory of ‘2-2-2 rule’ which is mostly used in decisions involving refinancing. This theory implies that if the rate of interest has decreased by two points below the existing mortgage, if the owner has already paid two years of his mortgage loan and if there are plans to stay on in the same house for the next two years; only then is refinancing thought to be feasible. However, this way of thinking does not have a lot of followers either, because other points such as tax deductibility of interest rates, value of cash flows etc are not taken into account at all.
- A better way to arrive at a decision of this kind is to take the following into consideration-
- The value at present of the cash flow of the existing mortgage after tax should be considered.
- The value at present of the cash flows of the proposed mortgage after tax should also be taken into account.
- Compare the two.
- The result with the lower present value should be taken.
An important thought to take into account is also under what circumstances is it feasible to apply for refinancing. Below are some options :
Firstly, if the interest rate has dropped two points below your existing interest rate.
If there is an increase in income since the first mortgage was taken, refinancing is a good option. Refinancing the mortgage could also lead to the reduction in the term of the mortgage. A refinance also allows you to make larger principal payments so that the mortgage can be finished off sooner.
If you have a mortgage with a varying interest rate or which is adjustable, refinancing would mean that you could pay a lot lesser with a lower fixed interest rate.
Simply wanting a reduction in the monthly payment itself is a good enough reason. Also because the loan repayment period can be extended which leaves room to take care of other expenses? Since a similar loan with lower interest rates will be applied for, it means that the installments on a monthly basis themselves would be reduced to a large extent. A slightly higher interest rate can still be balanced out with a longer repayment period. It is important to look carefully at the duration of the repayment period vis a vis the interest rate so that there are no chances of over spending.
The important point about taking a mortgage is the flexibility it offers. So if you are on a mortgage repayment where the interest rate is variable, taking a refinance makes sense because you can capitalize on the lower rate. At the same time, if there is no sign of the interest rates lowering at all at present, going for an option which allows you a variable rate of interest at a later date makes sense. In that way as and when the rates show a downward trend, a switch can be made. However, it must be remembered that the interest rates could swing both ways. If the market shows a lot of signs of being unstable, going for a fixed rate would be better. Not only would that enable you to plan properly about how you would repay the loan but you would also have a better control of the finances.
Refinancing is a good option if you are looking at refurnishing the house, buying more furniture etc. Assuming that you would have repaid a certain sum of the mortgage, a refinance of a higher amount than the outstanding loan can also be applied for by you.