| Home Center: Invest in a House |
1. Refinance can be Big Savings
Whenever interest rates drop, as they sometimes do when Alan Greenspan gets a little out of hand, homeowners might have the opportunity to save money. Lower interest rates generally translate into lower mortgage loan rates, and refinancing your mortgage at a lower rate can save you a few bucks on every monthly payment.
Deciding whether to refinance your home comes down to a basic calculation: Will your savings from reduced mortgage payments be greater than the up-front costs? Therein lie the guts of the refinancing decision.
Lose the thumb, use a calculator
When it comes to making this kind of financial calculation, everybody wants a simple "rule of thumb," and the financial trade is usually quick to oblige. Most commonly we are told to look for a minimum interest rate improvement of, say, two percentage points from our existing mortgage before we get serious about refinancing.
When it comes to mortgage refinancing, however, such rules of thumb can be misleading. The interest rate cut required to come out ahead will vary dramatically depending on how long you plan to hold the new mortgage, how many years you've already paid on the current mortgage, and the increasingly available opportunities for cutting closing costs.
It's hard to come up with one rule that covers all the possible scenarios with reasonable accuracy. However, you can take the specific numbers that match your unique situation -- how much remains on your loan, what rate you're currently paying -- and input them into an online calculator.
For example, the Fool provides a simple "What will my refinancing costs be?" Calculator that serves nicely as a checklist of common closing costs. Use it as a guide for surveying potential lenders. Once you get the data from lenders and plug it into the calculator, you will be given expected closing costs -- the size of the interest-savings hurdle you must jump to come out ahead.
Your refinancing savings
The second half of this calculation is how much you'll save in mortgage interest payments after refinancing. This is generally a clear-cut calculation, with one catch: To cover closing costs, you have to shell out today's money, but the interest savings you capture in return will arrive in the future, over time. Since the time value of money dictates that tomorrow's one dollar isn't as valuable as today's, it makes sense to convert your future interest savings to today's dollars for a fair comparison to closing costs, particularly if you'll be holding the new mortgage for many years.
If that last paragraph tied you up in mental knots, never fear. Our second refinancing calculator, "Am I better off refinancing?," takes care of the math behind the scenes and spits out an answer for you. If you worked through the closing costs calculator first, you'll find that a lot of the required information for this second calculator will already be in hand. You'll just have to add information about your existing mortgage, the loan you're trying to beat.
Are there any other reasons to refinance?
You may have an adjustable-rate mortgage (ARM) and find that you're uncomfortable not knowing exactly what the payments will be -- so you'd like to switch to a fixed-rate mortgage.
Alternatively, you might want to stick with an ARM, but you may have found one with a lower interest rate, or with appealing features such as payment caps that are lacking in your current loan.
If you choose not to refinance, you might still ask your current lender whether it is possible to modify your current loan in order to have it better serve your needs.
One caution
Should your current mortgage include a prepayment penalty, this could be a problem. If it is large enough, this penalty could offset the savings you gain by refinancing in the first place. Your current mortgage documents will indicate whether there is a penalty for prepayment. If there's any question, ask the lender for clarification.
2. Borrowing Against Your Home
When faced with a significant expense, such as medical costs, a new addition to your house, or a child's college education, you may find that you don't have the necessary cash on hand. In such a situation, you may want to consider a home equity loan or line of credit.
By using the equity in your home, you may qualify for a sizable amount of credit, available for use when and how you please, at an interest rate that is relatively low. Furthermore, under the tax law -- depending on your specific situation -- you may be allowed to deduct the interest because the debt is secured by your home.
Before deciding whether to head down this road, you should carefully weigh the costs against the benefits. Shop for the credit terms that best meet your borrowing needs without posing undue financial risk. And, remember, failure to repay could mean the loss of your home.
There are actually two variations on this home equity theme: lines of credit and loans. When comparing the two, however, keep in mind that you cannot simply compare the Annual Percentage Rate (APR) for a loan with the APR for a home equity line because the APRs are figured differently. The APR for a loan takes into account the interest rate charged plus points and other finance charges. The APR for a home equity line is based on the periodic interest rate alone. It does not include points or other charges.
Of course, there are plenty of other factors to keep in mind when considering either arrangement, as we discuss in other articles in this section.
3. A Home Equity Credit Line
One way to borrow against the value of your home is a home equity line of credit, which is a form of revolving credit in which your home serves as collateral. With a home equity line, you will be approved for a specific amount of credit -- your credit limit -- meaning the maximum amount you can borrow at any one time while you have the plan.
Many lenders set the credit limit on a home equity line by taking a percentage (say, 75%) of the appraised value of the home and subtracting the balance owed on the existing mortgage. For example:
Appraisal of home: $100,000
Percentage of appraised value: $75,000 ($100,000 x 75%)
Less mortgage debt of $40,000
Potential credit line: $35,000
In determining your actual credit line, the lender also will consider your ability to repay, by looking at your income, debts, and other financial obligations, as well as your credit history.
Home equity plans often set a fixed time during which you can borrow money, such as 10 years. When this period is up, the plan might allow you to renew the credit line. In addition, some plans might call for payment in full of any outstanding balance. Others might permit you to repay over a fixed time, for example 10 years.
Once approved for the home equity plan, usually you will be able to borrow up to your credit limit whenever you want. Typically, you will be able to draw on your line using special checks.
Under some plans, borrowers can use a credit card or other means to borrow money and make purchases. However, there might be limitations on how you use the credit line. Some plans might require you to borrow a minimum amount each time you draw on the line (for example, $300) and to keep a minimum amount outstanding. Some lenders also might require that you take an initial advance when you first set up the line.
What should you look for when shopping for a plan?
If you decide to apply for a home equity line, look for the plan that best meets your particular needs. Look carefully at the credit agreement and examine the terms and conditions of various plans, including the annual percentage rate (APR) and the costs you'll pay to establish the plan. And remember, the disclosed APR will not reflect the closing costs and other fees and charges, so you'll need to compare these costs, as well as the APRs, among lenders.
4. Cost of A Home Equity Credit Line
Many of the costs in setting up a home equity line of credit are similar to those you pay when you buy a home. These costs include:
a. A fee for a property appraisal, which estimates the value of your home.
b. An application fee, which may not be refundable if you are turned down for credit.
c. Up-front charges, such as one or more points (one point equals one percent of the credit limit).
d. Other closing costs, which include fees for attorneys, title search, mortgage preparation and filing, property and title insurance, as well as taxes.
e. Certain fees during the plan. For example, some plans impose yearly membership or maintenance fees.
f. You also may be charged a transaction fee every time you draw on the credit line.
You could find yourself paying hundreds of dollars to establish the plan. If you were to draw only a small amount against your credit line, those charges and closing costs would substantially increase the cost of the funds borrowed.
On the other hand, the lender's risk is lower than for other forms of credit because your home serves as collateral. Thus, annual percentage rates for home equity lines are generally lower than rates for other types of credit. The interest you save could offset the initial costs of obtaining the line. In addition, some lenders may waive a portion or all of the closing costs.
5. Interest Rate on Home Equity Credit Line
Home equity plans typically involve variable interest rates rather than fixed ones. A variable rate must be based on a publicly available index, such as the prime rate published in some major daily newspapers, or a U.S. Treasury Bill rate. The interest rate will change, mirroring fluctuations in the index.
To figure the interest rate that you will pay, most lenders add a margin, such as two percentage points, to the index value. Because the cost of borrowing is tied directly to the index rate, it is important to find out what index and margin each lender uses, how often the index changes, and how high it has risen in the past.
Sometimes lenders advertise a temporarily discounted rate for home equity lines -- a rate that is unusually low and often lasts only for an introductory period, such as six months.
Variable rate plans secured by a dwelling must have a ceiling (or cap) on how high your interest rate can climb over the life of the plan. Some variable rate plans limit how much your payment can increase and also how low your interest rate can fall if interest rates drop.
Some lenders might permit you to convert a variable rate to a fixed interest rate during the life of the plan, or to convert all or a portion of your line to a fixed-term installment loan.
Agreements generally will permit the lender to freeze or reduce your credit line under certain circumstances. For example, some variable rate plans might not allow you to get additional funds during any period the interest rate reaches the cap.
6. Repay Home Equity Credit Line
Before entering into a plan, consider how you will pay back any money you borrow. Some plans set minimum payments that cover a portion of the principal (the amount you borrow) plus accrued interest. But unlike the typical installment loan, the portion that goes toward principal may not be enough to repay the debt by the end of the term. Other plans may allow payments of interest alone during the life of the plan, which means that you pay nothing toward the principal. If you borrow $10,000, you will owe that entire sum when the plan ends.
Regardless of the minimum payment required, you can pay more than the minimum and many lenders may give you a choice of payment options. Consumers often will choose to pay down the principal regularly as they do with other loans.
Whatever your payment arrangements during the life of the plan -- whether you pay some, a little, or none of the principal amount of the loan -- when the plan ends you may have to pay the entire balance owed, all at once. You must be prepared to make this balloon payment by refinancing it with the lender, by obtaining a loan from another lender, or by some other means. If you are unable to make the balloon payment, you could lose your home.
Monthly Interest Payments
With a variable rate, your monthly payments may change. Assume, for example, that you borrow $10,000 under a plan that calls for interest-only payments. At a 10% interest rate, your initial payments would be $83 monthly. If the rate should rise to 15%, your payments will increase to $125 per month. Even with payments that cover interest plus a portion of the principal, there could be a similar increase in your monthly payment, unless the agreement calls for keeping payments level throughout the plan.
Selling Your Home
When you sell your home, you probably will be required to pay off your home equity line in full. If you are likely to sell your house in the near future, consider whether it makes sense to pay the up-front costs of setting up an equity credit line. Also keep in mind that leasing your home may be prohibited under the terms of your home equity agreement.
7. Another Option: Home Equity Loan
If you are thinking about a home equity line of credit, you also might want to consider a more traditional loan: the home equity loan. Also known as a second mortgage loan, this product is built around the fact that you have already paid for some portion of your home, and can now borrow against that equity.
This type of loan provides you with a fixed amount of money repayable over a fixed period. Usually the payment schedule calls for equal payments that will pay off the entire loan within that time. You might consider a traditional second mortgage loan instead of a home equity line if, for example, you need a set amount for a specific purpose, such as an addition to your home.
Disclosures from lenders
The Truth in Lending Act requires lenders to disclose the important terms and costs of their home equity plans, including the APR, miscellaneous charges, the payment terms, and information about any variable rate feature. In general, neither the lender nor anyone else may charge a fee until after you have received this information. You usually get these disclosures when you receive an application form, and you will get additional disclosures before the plan is opened. If any term has changed before the plan is opened (other than a variable rate feature), the lender must return all fees if you decide not to enter into the plan because of the changed term.
When you open a home equity loan, the transaction puts your home at risk. For your principal dwelling, the Truth in Lending Act gives you three days from the day the account was opened to cancel the credit line. This right allows you to change your mind for any reason. You simply inform the creditor in writing within the three-day period. The creditor must then cancel the security interest in your home and return all fees -- including any application and appraisal fees -- paid to open the account.
8. All About Reverse Mortgages
A reverse mortgage allows you to convert the equity in your home into a lump-sum payment, monthly income, or a line of credit.
Why would you want to do that? Well, it can be a useful strategy in retirement (you must be at least 62 years of age to qualify for such a mortgage) if you want some extra income. It's called "reverse" because it reverses the direction of the payments: instead of building up equity in your house by putting the money in, you actually reduce equity in the house by taking money out.
No payments are made on the loan until you no longer occupy the home as your primary residence. When you move or sell your home, the loan balance is due and payable. However, the loan balance is never allowed to exceed the value of your home.
What are the eligibility requirements for a reverse mortgage?
a. You and all co-borrowers must be a minimum of 62 years old.
b. The home should have a very low mortgage balance or be owned free and clear.
c. The home must be owner-occupied. FHA-approved condominiums and two- to four-unit dwellings (owner occupied) are also eligible.
How is my equity determined?
The allowable equity is calculated based on three factors:
a. The youngest borrower's age
b. The appraised value of your home
c. The FHA maximum loan limit for your county
What fees are involved?
Like most loans, you will pay an origination fee, appraisal fee, title fee, escrow fee, recording fee, and a monthly servicing fee. These fees can be included in your loan balance, if there is enough equity available.
What happens when the loan balance exceeds the value of my home?
You must occupy the property, and are responsible for maintenance and payment of taxes and insurance. As long as you abide by the loan agreement, you cannot be forced to sell or vacate your home. No deficiency judgment may result from your reverse mortgage. FHA insurance guarantees against any loss to the lender.
What if my home is in need of repairs?
With the reverse mortgage, repairs can be paid for out of the available equity. Some of the repairs can even be done after your loan has closed and funded.
How will this affect my heirs?
Upon your death, the loan balance becomes due and payable. Your heirs may repay the loan by selling your home, or refinance the reverse mortgage and keep the home. If your home has appreciated in value, you are required to pay back only the outstanding balance. Any money that remains after the mortgage is paid would go to your heirs.
Will this affect my Social Security income?
Reverse mortgage loan funds do not affect your Social Security or Medicare benefits. However, Social Security income benefits are limited, and you must structure your cash payments to follow those guidelines. Additionally, Medicaid, Aid to Families with Dependent Children (AFDC), and food stamps all have different eligibility requirements. We recommend that you contact your local agency on aging, or these agencies' respective offices, for their particular guidelines.
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