Why Should One Refinance a Mortgage?

By Charles Hopkins Published 10/26/2007 | Finance
Mortgage refinancing basically involves taking a new mortgage to pay off an old one, an idea which seems asinine to the uninitiated.  Get new debt to get out of old debt?  The key to understanding how this works is to know what a mortgage is and how it works in the first place, then one can understand why mortgage refinance is an option that some people take.

Mortgage Basics

A mortgage is a secured loan - secured meaning that the borrower offers something of value in case he or she is unable to pay the amount borrowed within the agreed-upon time.  This is known as collateral and usually takes the form of property or possessions of value such as cars, appliances, etc.  For example, a person can borrow money to finance the purchase of a house.  There are several types of mortgage deals, but the main difference among them is the interest rate.  Fixed-rate mortgages will never change throughout the lifetime of the loan (which can last anywhere up to thirty years), ensuring you know what amount you'll need to pay every period but at the cost of paying higher than you should when interest rates go down.  Variable-rate mortgages (also known as Adjustable-Rate Mortgages or ARMs) have interest rates that fluctuate with the economy, thus, allowing the borrower to benefit from smaller payments when interest rates drop and making them suffer larger payments when these appreciate.  Hybrid mortgages also exist which try to combine beneficial features of both fixed- and adjustable-rate deals.

Reasons Why People Refinance

People undertake mortgage refinancing for a variety of reasons, such as:

1.    To benefit from the equity of their home.  A cash-out mortgage refinance deal gives the owner the ability to put the value contained in their property to work, paying off credit card bills, doing home improvements, financing education, and so forth.

2.    To switch to a fixed-rate mortgage when the time is right.  ARMs are great for those who don't plan on owning the property for more than a few years because of the lower interest rates they're offered with compared to fixed-rate loans.  But if the homeowner is planning on staying put, the stability offered by a fixed-rate mortgage might be more desirable in the long term.

3.    To lower one's monthly mortgage payment.  Perhaps a new deal has come onto the market which the homeowner could benefit from.  Maybe he or she has moved into a higher income bracket or maybe the property has increased in value - these are all valid reasons why some people refinance their mortgage.  Every mortgage refinance has what is termed as its 'break-even' point, the point beyond which the money one will save will be greater than the cost of setting up a new loan.  If one isn't going to stay in a property long enough to reach this point, it makes no sense to refinance a mortgage.

It is impossible to be dogmatic about whether or not a mortgage refinance is ideal for any one person since everyone's financial circumstances are different.  It might be the best option for a person, but that person must still do the research, seek professional advice and check the math.