Refinancing to Build Home Equity

Homeowners and investors see to take advantage of historically low mortgage rates in 2012. During the third quarter, mortgage refinancing reached 2010 activity levels. The effects of mortgage refinancing benefit homeowners. Refinancing mortgages at a lower rate than the mortgage loans held by homeowners enables substantial savings. According to the Federal Reserve Bank of New York, saving money on the interest portion of the mortgage loan allows homeowners to accelerate principal payments.

Refinancing builds home equity

For example, a homeowner currently pays on a fixed mortgage of 8 percent on a 30-year loan financing $200,000. He’s already paid five years on the current loan. The homeowner decides to refinance his mortgage and wants to understand how much he’s going to save. Let’s say the homeowner doesn’t have perfect credit but he does have a stable work history. His bank approves a 4.5 percent mortgage loan over 30 years. He pays 1.0 point plus closing costs of $1,200. His federal tax rate is 26 percent; his state tax rate is 5 percent.

Before refinancing, the homeowner makes a monthly payment of $1,467.53. After refinancing, he saves $504.12 per month! His monthly payment savings dramatically decline by $30,247.15. Interest paid declines from $73,361.44 to just $40,992.29: he saves $33,023.15. Net gains, after deducting savings, losses, and closing costs are $19,233.32. The homeowner’s wise decision allows him to maintain financial stability as he pockets additional savings.

Impact of shortening the mortgage loan

Author Liz Pullam Weston (“The 10 Commandments of Money: Survive and Thrive in the New Economy,” 2011) says the impact of making a higher payment each month also enables to homeowner to pay down principal more rapidly. In this example, the homeowner doesn’t decrease his mortgage loan term. He maintains a 30-year loan. But how much could he save by shortening the term of his mortgage loan to 15 years?

The monthly payment on his new 15-year mortgage at 4.5 percent is less than the currently monthly payment, moving to $1,454.56–a savings of +$12.97. However, the monthly payment savings shifts by $778.39, because the homeowner halved his mortgage loan term. He pays $1,901.40 in points and closing costs of $3,101.40. He increases equity and the time required to own the home. Combined savings, losses, and closing fees net $21,654.88.

Equity and private mortgage insurance
Private mortgage insurance (PMI) helps homeowners to buy a home with less than 20 percent down. The cost of PMI depends upon the size of the borrower’s down payment and the loan amount. According to the Mortgage Bankers Association of America, PMI costs the borrower approximately 0.005 of the loan amount. PMI premiums aren’t tax deductible.

According to the federal Homeowners Protection Act of 1998, lenders must notify their customers of the right to cancel PMI when equity reaches 80 percent or more. Lender’s may request that the borrower provide proof of the home’s current fair market value. Home equity is confirmed by a current fair market evaluation.

Automatic PMI cancellation also occurs when equity value reaches 78 percent of the property’s original value for most traditional conforming mortgage loans. For higher risk mortgages (that don’t exceed conforming mortgage limits), cancellation of PMI occurs at the loan mid-point. High risk jumbo or super-jumbo loans (exceeding limits of conforming loans) must automatically release the borrower from PMI at 77 percent loan-to-value ratio (LTVR).

For these reasons, refinancing at today’s lower mortgage rates benefits the homeowner by building equity faster!

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