What does it mean to Refinance a Mortgage?
Refinancing a mortgage is when you renegotiate your current mortgage loan agreement — usually to access the equity in your home — to replace it with a new loan agreement.
When people pay down the principal on their mortgage, they build up equity and by getting a refinance mortgage loan, they can tap into that equity. Because of this, refinance mortgage loans are also known as home equity loans as the meaning is the same.
What does the term “Equity in Your Home” mean?
It simply means that your home is worth more than what you owe on it. For example, suppose you bought a home for $450,000 four years ago, and took a 20-percent mortgage for $360,000. Now, four years later the home is valued at $650,000. Now suppose after 4 years your mortgage balance is $295,000 the equity in your home would be $355,000 ($650,000 – $295,000).
People refinance their mortgage to access the equity in their home for different reasons but these are the popular ones:
- To start a business
- To purchase another home
- Debt Consolidation
- To pay for tuition
- Home improvement
There are 2 other major reasons that may spur you to refinance your home that doesn’t involve accessing equity:
- To capitalize on lower interest rates (lower the cost of borrowing)
- To reduce your mortgage payment obligation
While refinancing your mortgage might give you a more attractive rate, there are other things to consider before you refinance:
1. The penalties for breaking your mortgage
- Variable-rate mortgages will typically attract a penalty of 3 months worth of interest
- Fixed-rate mortgage attracts a higher penalty based on the time left in the term and the interest rate differential (varies based on the lending institution)
2. The fees involved in refinancing:
- Lawyer fees
- Appraisal fees
If the pros outweigh the cons, refinancing is definitely a great idea. Here are some examples of situations where refinancing is definitely a smart choice:
- Unsatisfactory loan-to-value ratio due to bad credit history at the time of application.
For instance, perhaps you got a mortgage for 60% of the home value instead of the 80% that is given to someone with good credit.
- Unsatisfactory mortgage rate due to bad credit history at the time of application,
Even though the bank’s advertised rate was 2.5%, your interest rate may have been 3.5%.
- A shorter amortization period.
Your amortization period may have been 25 years because you’re considered a high-risk borrower. However, a low-risk borrower may get a 30-year amortization.
When refinancing your home, you have the option to refinance with the same lender or go with a different lender. My rule of thumb is to go to the lender that you are comfortable with and who gives you the best deal.
Your loyalty should be to your pocket and not to the bank. Truth is, if your bank is loyal to you and value you as a customer, and wouldn’t want to lose your business, they will match any deal another lending institution is offering you because, if another one deems you worthy of a more favorable loan agreement, then your bank should view you as even more worthy because you have been their customer for some years.
While I agree that refinancing your mortgage for debt consolidation is a wonderful strategy to quote and quote, wipe the debt slate outside of your mortgage clean, I don’t believe the way most people do it is the most effective strategy to save on interest and reduce their cost of borrowing or the burden of debt repayment.
Most people roll the debt into the mortgage, so a $30,000 debt, for instance, that could have been paid off in a few years using strategies like the Debt Roll-up or Debt Snow Ball one, is now amortized over a 20 or 25 year period. Hence, 20 years later you’re still paying for that vacation that was taken more than 20 years ago or that air conditioner that was purchased 22 years prior, which more likely has even died and been replaced once or twice since.
Here’s how I propose you refinance your mortgage!
- Reset your mortgage to the maximum time that your lending institution will allow.
- Take the equity in the home on a Home Equity Line of Credit (HELOC).
- Consolidate your debt using the HELOC.
- Devise a plan to pay off the HELOC as soon as possible.
Why is this strategy better than rolling the debt into your mortgage?
Let’s look at an example of the additional cost that rolling your debt into your mortgage can incur.
Suppose you refinance your mortgage today and roll in your debt of $30,000, and re-amortized for 25 years at an interest rate of 2.15% (prime interest rate minus 0.3 – the prime lending rate is 2.45% at the time of writing this blog).
Now for simplicity, let’s assume your mortgage rate remains at 2.15% for the life of the mortgage — and this is very unlikely in Canada since we don’t have 25- year term mortgages, and the prime lending rate changes with economic conditions. Here’s your payment summary:
Monthly Payment = $129.36
Total of 300 Payments = $38,807.54
Total Interest Paid = $8,807.54
Now suppose you put that $30,000 on your HELOC that attracts an interest rate of 2.95% (prime interest rate plus 0.5% — most HELOC has that rate but I have one HELOC that has the prime interest rate and another that is prime minus 0.3%).
If you amortize that $30,000 for 10 years at 2.95% this is what you’ll have:
Monthly Payment = $288.99
Total of 120 Payments = $34,678.84
Total Interest Paid = $4,678.84
I did a Compound Interest (interest is paid on principal and accumulated interest) calculation for the HELOC for simplicity, however, unlike mortgages, HELOCs attract Simple Interest (interest is paid on principal only) so the interest amount will be a bit less!
If you commit to this payment, after 10 years you’ll free-up that $30,000 on your HELOC, plus the mortgage paydown will also reflect on your HELOC to increase the amount of funds available.
You could then use that HELOC to do one of the following:
- Start that new business that you dream about every day
- Purchase that rental property for your retirement
- Pay for your children’s tuition (student loan attracts higher interest rate than HELOCS, so even if it’s a loan to your children, you will be saving them on interest charges)
Of course, if you have low financial literacy skills and you’re not smart with money, you could put yourself right back in debt again and be back at square one. This is why it is important that you attend my financial literacy workshops to learn more about debt management, managing your finance, cash flow, saving for retirement, and much more. Click here to register for the workshops.
So, to answer the question: Should I refinance my mortgage loan?
I would say if the fees are affordable, definitely yes!
In fact, even if the fees are not affordable, you can roll them into the mortgage if you know your gains from having access to the extra funds will far outweigh the refinance fees.
I used the mortgage refinancing strategy to have a large real estate portfolio and I refinanced even when the penalty was high because I knew having the funds to pay down for another property would create far more rewards than the penalties I paid for refinancing — and it certainly did!
If you don’t think that you’re financially savvy but thinking of refinancing your home to utilize the equity in your home, talk to me — or a qualified financial planner of your choice — so you will understand your particular options. Many homeowners find that refinancing is much better than getting a different loan for debt consolidation or for college tuition for example.
Many refinance mortgage loans will have a lower interest than a student loan or a home improvement loan, so it will pay off in the long run to explore all of your options to be able to make an informed decision where refinancing your mortgage is concerned.