June Olsen writes: In the current economic climate, homeowners often feel the need to have substantial cash reserves available for medical expenses, remodeling projects, or to pay off consumer debt. Others may look to lower their mortgage payments in light of cash flow issues. These homeowners often rely on refinancing their mortgages to accomplish these goals. While many homeowners attempt to use refinancing as a tool to remedy these problems, the practice is not without its pitfalls. These pitfalls were disregarded when taught in accredited mba courses and as a result helped fuel the sub-prime mortgage crisis.
Why Do Homeowners Refinance Mortgages?
The Federal Reserve web site offers some options on why homeowners may choose to refinance their mortgages.
Lower Interest Rates
Market conditions can lead to lower interest rates. Since mortgage payments are tied to interest rates, homeowners can reduce their payments by refinancing.
Adjust the Mortgage Term
Some homeowners may want to shorten the term of their mortgages to pay off the home sooner. Others may want a longer term with lower payments.
Homeowners can also “cash out” some or all of the equity they have built up during the course of the mortgage by taking out a new mortgage higher than the home’s value.
What are Sub-prime Mortgages?
The US Department of Housing and Urban Development (HUD) defines “sub-prime lending” as “loans (that) are for persons with blemished or limited credit histories.” In most cases, these loans have higher interest rates and less favorable terms than those for borrowers with a better credit rating. As a consequence, loans from sub-prime lenders have a higher default rate than those from prime lenders.
What are the dangers of a refinanced mortgage?
Switching to an Adjustable Rate Mortgage
Some homeowners seek to take advantage of lower interest rates by converting their fixed-rate mortgage into an adjustable rate mortgage (ARM). However, when interest rates rise again, so do the monthly payments on an ARM.
Lengthening the Mortgage Term
While stretching the term of a mortgage (e.g. from a 20-year loan to a 30-year loan) will reduce the monthly payments, the borrower will pay more interest and less principal over the longer term. With lower principal payments, the borrower’s equity will also be lower.
“No Cost” Refinancing
Homeowners who choose to roll the closing costs of their new loan into their monthly payments may face a higher interest rate than those who pay the closing costs separately. Also, no-cost loans come with high penalties for early payoffs so that lenders can recoup the interest they would have gained if the loan had gone to term.
How can I prevent a foreclosure?
The best way to prevent a foreclosure is to examine every aspect of the refinancing, from loan term t interest rate fluctuations to closing costs. Also, finding a lender that is willing and able to communicate the potential hazards of refinancing while educating a borrower on the benefits of a home loan can also be beneficial.
Refinancing can be a useful tool for homeowners seeking to work through financial difficulties. As with any tool, a working knowledge of how best to apply refinancing can be the difference between a successful project and a devastating foreclosure.