Common and Costly Mistakes To Avoid When Refinancing Your Mortgage

In order to discuss and understand what NOT to do when you are refinancing your mortgage, we should first cover some basics about mortgages, refinancing, and the reasons why a person would want to refinance in the first place.

In terms of the actual nature of a mortgage, there is very little difference between a mortgage and a loan except that a mortgage is always for a home, it is generally paid back over a longer period (5-40 years), and the home itself is used as collateral. Because the real estate that you are buying is used as collateral, this is what is referred to as a 'secure loan.'

When a borrower (you) and a lender (usually the bank) agree upon the terms and time frame of the mortgage, one of the most important things that is in question is the Interest Rate (usually cited as an APR percentage, meaning annual percentage rate). This determines how much the borrower will eventually pay back to the lender.

The concept behind an interest rate is very simple, and has been practiced for thousands of years. If Party A lends money to Party B, and Party B agrees to pay back that money at a later date, Party B will always pay back MORE than the total amount borrowed simply because they had the use of that money over the specific arranged timeframe.

When it comes to refinancing a home loan or mortgage, many people have heard of it and know they can save money this way, but might not know exactly how to do it. When you refinance your mortgage, you will generally work with a different lending institution that agrees to buy out your existing mortgage, and you will then make payments to this new institution instead of your old one.

Although the majority of families looking to refinance their mortgage wish to do so to take advantage of lower interest rates, a few other reasons would be to raise a lump-sum of cash, or to secure against possible volatility in their interest rate values. This last reason, preventing the possible raising of interest rates, usually amounts to switching from an adjustable rate mortgage (ARM) to one with a fixed interest rate.

When a borrower wishes to refinance their mortgage to obtain immediate cash, this is called 'Cash-Out Refinancing,' and many people make costly mistakes in this process which you will learn to prevent below.

-----Mistakes To Avoid With Cash-Out Refinancing----

Cash-out refinancing is borrowing more than the total cost of your home in order to have a chunk of cash left over after you have repaid your existing mortgage.

If you are looking to get some cash to work with using a mortgage, this simply means that you are getting a loan based on the value of your home, with the home itself as collateral. You have two options when it comes to this, and which one you should use pretty much depends solely on the interest rates available to you. You can either obtain a second mortgage for the value of the amount of cash that you need, or you can let your new bank know that you need the value of your new mortgage to be HIGHER than the value of your existing one.

Now when most people hear about taking a second mortgage out, their brain tells them that they must avoid this at all costs as it may put them further in debt. But this is not always right, because usually with cash-out refinancing the bank or lender will charge you a higher interest rate than if the value of your new mortgage was THE SAME as your old one.

For the sake of ease and simplicity, let's just use some basic round numbers in this example: The existing value to be repaid on your mortgage is $200K, and you need $20K cash for something like a hospital bill (or maybe a generous donation to your Tropical Vacation trust fund). You can refinance your mortgage at $220K at 7%, or you can obtain a second mortgage of $20K at 12%.

Which one is better? Most people would say that refinancing in this case would be better, because they are conditioned to think that a second mortgage is an indicator of poor financial health, and also they are scared off by the higher interest rate. However, the total amount of interest that you would eventually repay on this smaller second morgage is far less than what you would repay for the larger refinanced mortgage.

----A Common Mistake When Refinancing For Lower Interest Rates----

Everybody should agree that it makes sense to refinance your mortgage if you are able to secure a lower interest rate, but at what point does this strategy become profitable?

When most people go about trying to find the answer to this question, the two things that they compare are only their current interest rate and the interest rate they will get if they refinance. The one thing that they will often forget, and the thing that you now know to take into account, is the COST that the new bank or lending institution will charge for the refinancing.

Depending on the bank, the current prevailing interest rate, and the amount of the mortgage, this cost can sometimes be large to the point that it will actually negate the money that you save from the lower interest rate!