Once you have decided that the only way forward to make that dream home purchase…
Mortgages are long-term commitments. Sometime during the life of the loan, you will experience exceedingly different circumstances compared to when you first applied for your mortgage. You might find yourself with a better credit score, thanks to on-time bill payments. You might even have a tidier sum put away in the bank at this time. You can get to a point when you might start thinking about the original terms of your loan and compare it to the opportunities now available to you.
If you find yourself in a better financial position, one option you might explore would be recasting your mortgage. After all, if you are comfortable enough with your liquidity, you can take this opportunity to score some savings for yourself. But what does it mean to recast a mortgage?
When is it a good thing, and what are the drawbacks?
Recasting a Mortgage
When you recast a film in Hollywood, you look for new actors to play the same characters. When recasting, you essentially change something but not everything. This is also true when recasting mortgage.
For most mortgages, you typically make two types of payments. First, you pay the initial lump sum payment (for mortgages that require a minimum down payment) that includes other mortgage expenses like closing costs, origination fees, and so on. Finally, you start paying monthly mortgage payments until you can gain complete home equity.
When you recast your mortgage, you will be making a second lump-sum payment. It could be because you recently got a windfall from a relative, or you have been able to keep more savings than you expected. This can happen anytime within the life of the loan, and it will be absolutely up to you to pay it. This lump sum of money will be paid toward the principal balance of the mortgage that will, in effect, lower your monthly payments. However, it will not shorten your mortgage term or change the interest rate contracted through your loan.
Imagine that you have a 300 thousand dollars worth 30-year mortgage. You are already 10 years into your loan payments, and right now, you have 200 thousand dollars in the principal balance left. A deceased relative recently left you an inheritance of 50 thousand dollars, and you want to forward this lump sum to your mortgage to reduce your monthly payments. Now you will only have a loan balance of 150 thousand dollars for the next 20 years. In summary, the mortgage’s interest rate did not come into the equation at all, and even if you have a lower loan balance at this point, you are still observing the original 30-year term. Moving forward, you now have lower monthly payments as well as 50 percent home equity.
Sounds pretty simple, right?
Unfortunately, not all types of mortgages can be recast. If you have a government-backed loan (typically FHA, VA, or USDA loans), you are automatically ineligible for mortgage recasting. However, if you have a conventional loan from one of the major banks like Bank of America or Chase, recasting your mortgage is possible. (Take note that very few jumbo loans can go through mortgage recasting.) It would help if you spoke to your lender to let your intentions be known and be informed of your options.
Pros and Cons of Mortgage Recasting
It seems like a sweet deal to save money that might otherwise go to interest payments. Right now, you might be asking, “What’s the catch?”
Well, this sweet deal does come with its own strings attached. But depending on your financial situation, these don’t have to be too heavy as repercussions go.
Locking funds in home equity
Most people finance their homes through mortgages for exactly the reason that this gives them better liquidity. Even if they may have the cash already sitting in the bank, they still opt to apply for a loan just for the convenience of keeping that cash available for when they need it.
Recasting a mortgage may mean a blow to some of that liquidity. Circumstances can always arise wherein you could get the opportunity to use these funds for other investments, like home improvement, a new vehicle, or even a small business. In the worst-case scenario, that opportunity might instead be a necessity, for example, a medical emergency that lands you in the hospital. You might be able to save money in the long run, yes, but you might also need that money to fund the more important things in your life.
Paying additional fees
The savings through fewer interest payments will also come much later. However, when you do opt for a mortgage recast, you will have to pay a fee again upfront.
That fee will vary depending on the lender. While this might not even mean a thousand dollars for most lenders, regardless of your lump-sum payment amount, it can still knock off some of your cash that you could better spend somewhere else.
Lenders decide how much.
Although you might arrive at this decision due to a cold, hard cash amount, it’s still the prerogative of lenders how much exactly they will be bumping off your principal balance. Your lender may ask for a specific minimum amount, and this could also be a percentage of your remaining mortgage loan. You can get lucky and have more than the mortgage recasting requires, but there is always the off chance that you might fall short of what your lender needs to approve your mortgage recast.
Recasting vs. Refinancing
There’s also the important consideration of whether you’re better off refinancing your mortgage. This will depend on a few factors. But first, let’s find out what it means to refinance a mortgage.
What’s the difference?
When you get a mortgage recast, you will essentially retain your lender, your interest rate, and even your original loan term. The only thing you’ll be changing is the remaining principal amount, leading to lower monthly payments.
On the other hand, refinancing means getting a new mortgage altogether to replace your existing loan. A new application means a new lender, a new monthly interest rate, and new loan terms. You won’t be changing the principal balance, but your monthly payments will definitely get updated. Take note that refinancing does not always lower your monthly payments. That will depend on your intent. (We recommend, though, to only refinance your mortgage if it means a cheaper bottom line for you, even with a new round of fees to pay.)
When to Refinance a Loan
Deciding on which would be best for your mortgage is a little tricky. Typically, people refinance their mortgages to move from a fixed-rate one to an adjustable-rate mortgage, i.e., when the market causes the interest rate to keep going down. When you stick with a fixed-rate mortgage while the interest rate decreases monthly, you end up paying more than the mortgage loan is really worth, losing money in the process. Once you switch to an adjustable-rate mortgage with a variable interest rate, you get to weather the loan market to protect your money.
Since you’ll be taking a new mortgage, to begin with, when you refinance your loan, this will mean going through all the same processes you experienced before, paying a new set of origination fees, closing costs, and more. The main advantage of refinancing will come from a lower interest rate and another chance at deciding your loan terms. If you previously had a 15-year mortgage, this time, you can get a 30-year loan. Keep in mind that you are in this position because you are now in a better financial situation. You probably have a higher credit score which means more negotiating power with your lender.
When it comes to mortgages, there’s never a one-size-that-fits-all approach. We all come from different financial backgrounds, serve in various professions, and have unique money habits.
Mortgage recasting and refinancing are just options that you can choose from to manage your monthly mortgage. There is always the choice to do nothing and see through the end of your remaining loan. After all, getting a new loan can take some time and effort to apply for, and you can’t count on a hundred percent chance that you will qualify. Even refinancing has its own fees that you might as well funnel the money to your education or other investments.
And if you are still undecided, here are a few questions that might help you think of what to do:
- How is the loan market at the moment?
- Is there a cheaper interest rate I might qualify for?
- Is recasting an available option? Is refinancing?
- How much will my monthly payment become if I recast? If I refinance?
- How much will I save when I pay less in interest after a recast? With a new loan?
- What other opportunities can my money bring to me?
Remember, the devil is always in the details. It’s time to roll up our sleeves and do the math!